The BoJ Tightens. The U.S. Gets Downgraded. Investors Say “Meh”.
They Really Shouldn’t.
Whether you believe that a recession is imminent or a credit event is near or the bond market is about to crash, we should be able to agree on the idea that the landscape has changed over the past week. No longer can investors just keep buying stocks because they believe that AI is going to take over the world. There are real events and real catalysts to consider when deciding how best to deploy capital from here. Two big ones revealed themselves over the past week.
The Bank of Japan & Yield Curve Control
The Japanese central bank took a minor step towards finally tightening monetary policy by effectively widening the band of its yield curve control policy. Now, it will use the 0.5% level on the 10-year JGB as a reference point, not a cap, and allow itself to buy bonds with yields up to 1%. That 0.5% to 1% range is a bit of a gray area though. The BoJ won’t necessarily allow yields to float freely up to the 1% level. Instead, they’ll monitor conditions within that area and buy as conditions warrant. This is the reason why the 10-year yield has topped out at only 0.65% thus far and the BoJ has already stepped in to buy bonds again.
Implications
The Bank of Japan is the last developed market holdout with regard to monetary tightening. That’s potentially a positive in terms of stimulating economic growth (although it hasn’t seen much benefit so far), but it’s come at a cost. The BoJ’s balance sheet has become incredibly bloated and the central bank has become, by far, the biggest player in the Japanese bond market. All of that liquidity has also killed the value of the yen. Year-to-date, the yen is down more than 8% against the U.S. dollar and roughly 27% since the beginning of 2021.
That’s led investors to using Japanese government bonds and the yen as a source of cheap funding. If they can short these things and use the proceeds to buy anything with more potential - Treasury bills, other currencies, tech stocks - they’ll continue doing it as long as the opportunity remains there. Even as the BoJ slowly starts to tighten, the carry trade is alive and well (and probably at least part of the reason why stocks have risen so much in 2023).
The numbers support it too. Net short positions in the yen are at near record highs and the dollar’s correlation to tech stocks is also at multi-year highs.
With these conditions currently in place, the big question is what happens when the big yen carry trade starts to unwind?
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