Japan has been a major engine of global liquidity for decades through the yen carry trade. After it’s bubble burst in 1989, Japan lowered interest rates to essentially zero and kept them there. This allowed for borrowing in yen for free and investing the money where yields were higher. This benefited both foreigners and the Japanese investing abroad, resulting in Japan being tbe largest holders of US treasuries. It also allowed the Bank of Japan (BoJ) to act as buyer of last resort for Japanese bonds without having to worry about interest payments. Japanese debt is the highest in the world, but mostly owed to itself, in its own currency at a very low rate, meaning the debt could be managed despite the enormous outstanding principle. Consumer prices remained flat, as did wages.
First the pandemic and now the war in the middle east have upset the balance, as both forced price rises. During the pandemic, other central banks were raising rates while Japan did not, but this impacted the value of the yen as money flooded into dollars instead. Japan tried to raise rates marginally, but this threat to the carry trade caused a minor panic, so rates were lowered again. Since Japan is not self-sufficient in essentials, it imports a great deal, including all of its oil and gas. A falling yen causes further price rises for commodities and goods priced in dollars, leading to BoJ intervention to try to protect the vale of the yen. However, buying yen merely fed the speculators who were shorting it on obvious weakness. Rising prices (ie prices denominated in falling yen ) have led to rising wages, threatening a wage-price spiral. Interest rates have since been raised again to protect purchasing power, but this both threatens the carry trade and greatly increases the cost of carrying the gargantuan debt.
Japanese bond yields, while still lower than in other jurisdictions, are still almost ten times as high as they were a mere four years ago. Unfortunately the perceived risk of holding them has risen substantially, meaning that potential buyers of Japanese debt will be demanding still higher rates. In the meantime, leveraged bets against the yen are increasing. Japan is in the unenviable position of being forced to choose between saving its currency or saving its bond market. The government wants to protect the bond market, keeping rates low enough that it can afford its payments, while the central bank wants to save the currency with higher rates. The rest of the world would like to avoid a disorderly unwinding of the yen carry trade, but such an outcome is increasingly likely. Higher bond yields are coming, meaning money coming home as the carry trade reverses and investment at home is encouraged. This will have severe effects on the global economy.
The likelihood of a fire sale of assets, including US treasuries, is rising as the burden of the huge Japanese debt rises on higher rates. The US wants to prevent this, as it would push up the borrowing cost on their own $40trillion in debt. Japan has been vassalised into the empire, so the US has leverage over it, both financially and militarily. Pressure may be placed on Japan to prevent the selling of treasuries, but their situation will break eventually anyway. If US yields on the ten year exceed 5% (currently about 4.6%), the US will find itself in an exploding debt scenario. A financial reset is coming, as the tensions in the global financial system are rapidly increasing, and limits are approaching. This could result in a knee-jerk flight to safety into the reserve currency, which would suppress the value of other currencies, including the yen. This could send prices of Japanese imports very much higher, especially for energy, and everything derived from it. The combination of skyhigh prices and the Japanese demographic timebomb, due to a chronically low birth rate, is very unfortunate. Pensions promises are very unlikely to be able to be kept as a highly indebted government tries to cope with far too few young people to fund a pension system, or other entitlements. Japan will not be the only country facing this conundrum, but it may well be the first to fall.
