Building carry risk

The week started on a mixed note. In Europe, the retreat in European bond yields gave a certain relief to equity indices, allowing the Stoxx 600 to keep floor above the 50-DMA, while major US indices failed to maintain earlier optimism – fueled by news that Washington reportedly proposed a temporary waiver on sanctions. The US denied the report shortly after.

This morning, we’re back to square one. Yields are rising and equities are under pressure. The Japanese 10-year yield – which has become the first thing I look at in the morning – is pushing toward the 2.80% mark again. Rising oil prices fuel inflation and Bank of Japan (BoJ) rate hike expectations, justifying the rise in yields, while economic data released this morning backs a further selloff: the Japanese economy grew more than 2% annualized in Q1, consumption rose more than expected, while price pressures did not ease as pencilled in by analysts. The latter boosted hawkish BoJ expectations – the expectation that the BoJ would raise rates to tame inflationary pressures – a scenario that echoes through US yields as well.

Japanese yields matter to the entire world

Why? Because Japan is one of the largest foreign holders of US Treasuries. For years, Japanese investors such as pension funds and insurance companies bought US government bonds because yields in Japan were extremely low — often close to zero — making US bonds far more attractive in comparison.

But that changes when Japanese government bond yields rise. If the 10-year Japanese Government Bond (JGB) yield climbs toward the 1.75–1.77% range, domestic bonds start becoming attractive again for major Japanese institutions: they can earn a decent return at home without taking the currency risk, hedging costs, or overseas exposure that comes with holding US Treasuries.

That matters because if large Japanese investors start shifting even part of their money back into domestic bonds, demand for US Treasuries could weaken, potentially putting upward pressure on US yields. And we see this morning that the US 10-year yield is pushing past 4.60% — the highest in a year.

In other news, China – another major UST holder – also joined the global selloff in US Treasuries in March amid rising geopolitical tensions.

Beyond the Iran war, China has been reducing the risk of holding US Treasuries for years, replacing part of its UST reserves with gold. The latter – echoed by other central banks – is expected to maintain gold’s positive longer-term trend.

Gold caught between yields and liquidity

In the short run, however, gold remains under pressure from rising yields – higher sovereign yields increase the opportunity cost of holding non-interest-bearing gold, making the yellow metal relatively less attractive compared to fixed-income assets. I believe every tick lower is an opportunity to strengthen a long-term bullish position.

The next reverse carry trade may be more than a temporary scare

Coming back to rising Japanese yields, the latter is becoming a growing risk for global markets. As the Japanese repatriate their money back home, US Treasury yields push higher, and higher US yields echo across global yields, while higher yields weigh on equity valuations. That’s called the reverse carry trade. The last time the latter happened, in August 2024 following a BoJ rate hike, the Nikkei lost nearly 20% in a few days, while the Nasdaq – exposed to cheap yen funding – dived around 14%.

Today, and with stretched valuations, a scenario like this becomes increasingly possible, especially if the BoJ moves ahead with another rate hike. The BoJ will meet on June 16–17 and is increasingly expected to raise rates from 0.75% to 1.00% at that meeting.

And how do you recognize a reverse carry trade? The biggest tell is a violent drop in USDJPY, combined with a simultaneous drop in equities and collapsing yields, confirming a risk-off deleveraging event.

This far, because Japanese yields remained notably low — and below the important 1.75–1.77% threshold for the 10-year JGB — reverse carry-trade episodes mostly resulted in temporary bouts of deleveraging and short-lived panic across global markets. Investors eventually returned to borrowing cheap yen and chasing higher returns abroad because the yield advantage still overwhelmingly favoured foreign assets.

But as we’re moving sustainably above that threshold, and as Japan is making its way out of a two-decade-long deflationary environment – which was the reason why Japanese yields were so low in the first place – we could see something far more structural happen. The next reverse carry episode could trigger a gradual – and sustainable – reallocation of Japanese capital back home, as domestic bonds start offering sufficiently attractive returns without the currency risk and hedging costs tied to overseas investments.

And that would mean structurally less liquidity for global markets, because Japan is one of the world’s largest pools of savings. A sustained repatriation flow could reduce demand for US Treasuries and global risk assets, put upward pressure on global borrowing costs, strengthen the yen structurally, and tighten global liquidity conditions after years of abundant Japanese-funded capital supporting everything from US tech stocks to emerging markets.

Keep calm and carry on

Now, that’s the theory.

In practice, if you ask me how worried I am, I am not extremely worried about lower Japanese liquidity. I am sure the Federal Reserve (Fed) and other central banks could fill the gap with QE, repo facilities, or any other liquidity programs designed to inject money into the system.

And that’s exactly why the durable and notable rise in the 10-year JGB yield above the 1.75–1.77% threshold did not lead to the massive selloff that many expected – and warned very loudly about.

On the contrary, global liquidity kept rising on a steep upward trajectory, and a large part of that liquidity eventually found its way into global equity indices and other risk assets. Duh!

That’s why it only makes sense to stay buy the next dip, and stay invested in equities when stock-price inflation appears inevitable due to sustained liquidity injections.

One last thing about money injection. The new Fed Chair Kevin Warsh is willing to reduce the size of the Fed’s balance sheet, and balance the negative impact by lowering rates. I don’t believe for one second that he could credibly do that.