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The Struggling US Economy

In August of last year, global markets—especially in the US—unexpectedly plummeted. This was long before Trump's tariff wars or China’s economic troubles, and it was largely due to the unwinding of the Yen carry trade. As Japanese interest rates began to rise and the Yen strengthened against the dollar, it triggered a massive sell-off in US stocks. At the height of this decline, US stocks fell by more than 8.5%, with over half of the drop coming from the top seven tech stocks, often referred to as "The Magnificent Seven." This was a sudden shock that caught everyone off guard, especially during a period when the US economy appeared to be thriving—Biden was president, and Yellen was spending aggressively. The economy was being propped up by deficit spending, which hit 6.7% of GDP.

The Changing Economic Landscape

Today, the situation is vastly different. There’s a push to rein in spending and cut down government expenditures. Trump's trade war is backfiring, and the effects are being directly felt in the markets. The S&P 500 has dropped 10% from its peak, entering correction territory. This has been one of the fastest market declines in US history, reminiscent of those seen in 1928. It’s no surprise, though—cutting deficits in an economy that’s heavily reliant on government spending leads to a decline in corporate revenues. The Atlanta Fed has forecasted a contraction of over 2% for Q2, and investors are questioning the value of holding US stocks, especially when valuations remain high.

The Risk of Government Spending Cuts

A significant risk to the economy is emerging. According to Bank of America, 34% of US GDP is driven by government spending, while the remaining two-thirds come from the private sector. Both are under considerable strain. With federal job cuts, people have less money to spend, creating a direct cause-and-effect relationship. The hope is to shift spending back to the private sector, but that’s challenging in the US right now. Job growth is increasingly skewed, with 85% of new jobs tied to federal employment or sectors that rely heavily on government spending, like healthcare and education. But how can job growth return to the private sector when their revenues are tied to domestic spending? Plus, Trump's trade war is causing global boycotts, which could cause foreign revenues to collapse in Q1 and Q2. The last thing the US needs is an external shock, but it seems one might be coming from Japan.

The Yen Carry Trade Risk

It’s crucial to understand how the Yen carry trade works, as it could spell disaster for the US. Over the past decade, Japanese investors have been borrowing Yen at near-zero interest rates, then investing that money in US Treasury bonds, earning a yield of over 5%. As long as interest rates stayed stable, they could reap a "free" 5% profit. If the dollar strengthened and the Yen weakened, it worked even better, as they could pay back their Yen-denominated debt at a devalued rate. However, in August 2024, this started to unravel, and the same conditions are emerging once more.

Rising Yen and Falling US Dollar

Over the last month, the US dollar has fallen sharply, while the Yen has strengthened rapidly against the USD. At the same time, US bond yields are dropping, while Japanese bond yields are rising. Since January, Japan’s 10-year bond yields have surpassed 1.5%, up from under 1.2%. This comes at a precarious time, as US yields are falling due to recession fears. The Bank of Japan is expected to hike rates further, which will likely put additional strain on the Yen carry trade. As Japanese bond yields rise, they become more attractive to local investors, prompting them to sell their US bonds and reinvest in Yen-denominated assets.

The Growing Pressure on the Dollar

This poses a significant problem for the USD. Since January, the Yen has appreciated by over 6% against the dollar. This drop is a major headache for Japanese holders of US debt. Even if they earn a 5% yield on their Treasury bonds, they still face a 1% loss when converting their dollar proceeds back into Yen to repay their loans. With Trump’s escalating trade war, the pressure on the dollar continues to mount. Investors, concerned about a recession, have driven US bond yields lower, making the Yen carry trade even less attractive. Scott Bassent recently confirmed the looming danger, especially with Trump’s upcoming tariff plan and reciprocal tariffs set to take effect in April.

Japan’s Potential to Derail the US Economy

Japan's influence on the global economy could severely impact the US in the near future. If Japan experiences economic turbulence, it may trigger a "rug-pull" effect, where Japanese investors pull their funds from US markets. This is particularly concerning with upcoming events, such as April 2nd, which could be a pivotal date. From April 2nd to June 30th, a shift in global dynamics could occur as other countries adjust their policies. President Trump's actions have created a situation where either tariff barriers will come down, allowing for more US exports and fairer trade, or if tariffs remain, the US will collect substantial revenues. However, this assumption holds that tariff barriers drop; if other countries retaliate, the demand for the US dollar could decline even further, causing the dollar to weaken.

The Growing Risk of a Dollar Decline

If the global demand for US goods falls, the strength of the US dollar could diminish even more. In response, Japanese investors, who hold significant US investments, could start withdrawing their funds. As of 2024, Japan's foreign investments have grown substantially, reaching nearly 490 trillion yen ($3.4 trillion), with much of it tied to US assets. As the US dollar weakens and US bond yields decrease, Japanese investors have more incentive to exit US markets and repatriate their funds. In fact, Japan’s exposure to US bonds is already increasing due to recession fears, with an additional $23 billion worth of foreign bonds purchased last month. This creates a risky environment, particularly as Trump seeks to push US yields lower while Japan considers raising its rates.

Japan’s Economic Struggles and Rate Hikes

For over a year, Japan has been battling higher inflation due to the weakening Yen. Despite their economic challenges, they are now cornered into raising interest rates to combat domestic price surges. This becomes a risky situation, as raising rates can exacerbate Japan’s debt problems, but they are left with no choice given the inflation pressures. The Bank of Japan (BOJ) is adamant about hiking rates to control rising prices, which are already outpacing those in the US and the Eurozone. Japan’s inflation has surpassed the US and Eurozone, with a 4% rise compared to 3% and 2%, respectively. This inflationary pressure is squeezing Japanese consumers, who are already struggling with higher savings rates and significant household debt. As inflation pushes prices higher, especially for imported food, Japan is under significant stress, and a stronger Yen is needed.

The Currency Strain and the Risk to US Markets

To strengthen the Yen, the Bank of Japan must raise interest rates, but this move could destabilize US markets. The combination of the BOJ and the Federal Reserve's policies puts both economies in a precarious position. While Trump’s economic policies are inadvertently pushing the Fed to cut rates, the BOJ is forced to raise theirs due to inflation. This imbalance could create significant volatility, particularly as Japan's regulator moves to clamp down on risky loans, many of which are tied to government bonds. This situation mirrors the 2008 mortgage-backed loan crisis, but with Japanese government bonds as the collateral. If these bonds lose value, it could trigger a major financial collapse, impacting global markets, including the US.

The Threat of a Systemic Financial Crisis

If Japan begins raising interest rates, the value of existing government bonds could collapse, eroding the value of collateral linked to these bonds. This could lead to significant losses, triggering defaults on repackaged loans, estimated at $67 billion. A default could spark a chain reaction, leading to a liquidity crisis. In recent years, more local Japanese lenders have been investing in these risky loans, increasing their holdings from under 3% to nearly 6%. If these loans collapse, lenders may be forced to sell their foreign assets, including US stocks and bonds, to cover the losses. This could create a massive ripple effect throughout the global financial system. What happens in Japan is deeply interconnected with the US and other global markets, and any upheaval in Japan could severely affect investment flows and financial stability worldwide.

Recession Fears Grow Amid Escalating Tensions

The challenges we face today are serious, and they are global in nature. As the US dollar continues to weaken and the trade war intensifies, the situation for US assets is becoming increasingly dire. In a recent interview, Besson stated that he isn’t concerned about market corrections, even going so far as to call them "healthy," which suggests that there’s no safety net, like the "Trump put" or a bailout, coming to the rescue.

Uncertainty Surrounding Recession Predictions

Besson did not dismiss the possibility of a recession, confirming that a plan to reduce government spending is still in motion. When asked if he could guarantee that there would be no recession on President Trump's watch, his response was telling: "There are no guarantees. Who could have predicted COVID-19?" He added, "What I can predict is that we’re putting in robust policies that will be durable. Could there be an adjustment? Yes, but if we had continued on this track, I can guarantee we would have faced a financial crisis. The massive government spending we’ve had is unsustainable. We need to wean our country off of it, and on the other side, we’ll focus on invigorating the private sector."

The Risk of Adjustment and Recession

When pressed on whether the "adjustment" could lead to a recession, Besson suggested there was no reason it had to, but emphasized that without change, the outcome would have been a financial crisis. He acknowledged that the current spending levels are unsustainable and that a reset is necessary to put the country on a sustainable long-term path. While I agree with him that the US deficit is unsustainable, his inability to guarantee an end to recession fears means that the short-term effects of reduced spending could send shockwaves through the market.

Global Factors Adding to the Pressure

The situation is further complicated by developments in Japan, which could potentially act as the final straw. The US is determined to slow down the forces driving stock prices higher, with every policy—from the Federal Reserve's actions to the ongoing trade war—focused on reducing the deficit. For US stocks, which have become accustomed to endless government spending, this shift in approach could spell significant trouble ahead.

The Future of US Stocks and a Possible Recession

What do you think? Will Japan further deflate US stocks? And can the United States avoid a recession in the long run? Share your thoughts in the comments.

Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.

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