It has been the most successful investor strategy over the past 30 years, but like everything it must come to an end. For 30 years, hedge funds, private equity funds and other investors have been borrowing in Yen and investing all over the world. The truth was that for the past 30 years the zero interest rates and the slowly depreciating Yen allowed the financial community to borrow massively (aka leverage) and generate higher returns.
How does this work? Well you borrow $1 million in the tokyo market, effectively you borrowed Yen 100 million at a rate of exchange of 105 to the US dollar. The interest rate on this loan is 1.3%. That's the start, the risk is that the Yen rises, that's it. You take that money and invest it at 4% (buying US treasury 10 year bonds for example), and you take the yield and declare it as your profit. Now let's say that you do this for $100 million, and that you used $2 million of your own capital (that's literally what happened). Your return on your $1 million is the difference between the $100 million you borrowed, and what you earned on your US bonds — lets call it 4 million a year (aka 4% on 100 million). However, your return is calculated on the investment you made in the trade, which is $ 2 million. Total profit for the trade is 100% per annum.
This example is a gross exaggeration, but it's not incorrect, in addition over the past 30 years the Yen's value had declined, from 105 to 165. That means that the carry trade is even more profitable.
What is happening? First, the era of 0% interest is dead in Japan. Five-years Yen bonds are yielding around 3.8% right now. That means that the carry trade is not as nearly as attractive, since the differential between five year US T-Bonds and five year Yen bonds is about 300 bp (aka about 3% for the laymen).
So what has been going on? In short, the investors in the 30 year carry trade have begun to unwind the trade, it has two impacts, first there is less demand for corporate yen bonds, which lowers the price, but also the Yen increases in value. These factors together make the trade "less of a sure thing" and so the big players are slowly, quietly exiting the trade.
What is the impact? Well one of the longest standing trades that has kept the Yen artificially down, is unwinding. This will reduce the cost of corporate debt in Japan (great for Japan), but also raise the Yen, reducing imported inflation (aka fuel costs).
What is the environment? The first reality is that Japan is in trouble, with a sovereign debt in excess of 220% of GDP, a quickly aging population (aka less tax revenues), and a shrinking global market (Japan is not the only country with negative demographics – not even the worst). The real pressure is rising interest rate costs due to Japan debt crowding out, but also the massive increase in US debt that is forever looking for new lenders ( 3 trillion to refinance this year alone). When the Japanese government borrows more, it pays more, the JGB is now around 2%, a lot higher than 0% less than three years ago.
When did this all happen? The first signs of trouble emerged in early 2020, made even more obvious by the pandemic. Japan is hollowed out. Even in Tokyo you can now purchase a home for very little money, there are far more homes than there are Japanese.
What does it mean for the rest of the world? For sovereign borrowers it's kind of bad. You can see it by the numbers: the percentage of US bonds held by Japanese insurance companies and pension funds has declined by half since 2020. The capital is repatriating, because the carry trade is no longer attractive (because corporate Japanese debt is now a lot more expensive). Both Japan and China have been shrinking their holdings of US debt, not for any real political reasons but because the numbers are no longer attractive. Japan and China were at one point the first and second largest buyers of US sovereign debt. They have diversified (a little) towards the EU, and also more telling, is that with an aging population insurance companies and pension funds now have to payout more than before (many insurance products were a form of savings by Japanese investors).
Why now? The 220% threshold was always going to be a problem. The domestic reality of Japan is that it is a shrinking economy (fewer people, older people) and as such its needs are different (pension and insurance products are being consumed by aging Japanese). In the short term, that's the end of that, but in the longer term the situation is different. First, the reduction of USD holding is not only a permanent feature, but is bound to accelerate, one of the features of the US bond market is its liquidity — if I contact a broker to sell a $50 million bond position, it will be liquidated in a few days (if not a few hours depending on factors).
For the UK the problem is as follows; we are a middle power (and I am being generous) we don't have much to offer the rest of the world. We are not a resource economy and will never be. The shrinking of the auto sector was always predetermined, but our exit from Europe made Sunderland an easy target for vehicle manufacturers. We have a large but shrinking government deficit (currently 4.2% of GDP to fall to 3.7% in 2026). Our total sovereign debt is around 85%. Lower than some (France 117%) but higher than others (Germany 63%). The Chancellor of the exchequer has to live within our means, reduce expenses, increase revenues.
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