Skip to content
Search
By  Arif Husain
Download the PDF

Ahead of the Curve: The San Andreas fault of finance shakes the markets

Monetary tightening in Japan is rearranging global capital flows.

August 2024, From the Field -

Key Insights
  • Bank of Japan monetary tightening and its impact on the flow of global capital is far from simple, and it will have a large influence over the next few years.
  • While yen strengthening and crowded trades were a handy explanation for early August’s volatility, my sense is it was the start of something, not the end.
  • From a Japanese domestic perspective, modestly higher Japanese yields could draw large flows back into the country in the longer run.

Thin summer liquidity conditions coupled with crowded leveraged positions across the market set the kindling for a potential market shock. And so in early August, all it took was a spark to ignite an extraordinary volatility shock. The Bank of Japan’s (BoJ) move to tighten monetary policy provided that catalyst.

The yen carry trade

At a recent T. Rowe Price Board meeting, one Board member quipped that over the last few days they had suddenly become an expert in the “yen carry trade.” Many fingers have pointed to this leveraged set of positions as the culprit for triggering the collapse in markets and the spike in the Chicago Board Options Exchange Volatility (VIX) Index. In my opinion, while the yen carry trade certainly played a part, it is more a convenient ex-post narrative to explain the price action than a true driver of the volatility. The scapegoating of the yen carry trade ignores the start of a bigger and deeper trend.

When talking with clients in 2023, I sometimes referred to the BoJ as the San Andreas fault of finance. That was early, but I believe that we have just seen the first shift in that fault, and there is more to come.  

BoJ loosens yield curve control

The BoJ has started gradually hiking rates. The Japanese central bank has also loosened its yield curve control policy, which uses Japanese government bond (JGB) purchases to essentially cap yields. The BoJ moved the upper bound of its benchmark interest rate to 0.1% in March from -0.1%—where it had been since early 2016—and raised rates again at the end of July, bringing the upper bound to 0.25%.

At its June policy meeting, the BoJ said that it will start to “significantly” scale back its asset purchases from its current JPY 6 trillion monthly pace over the next one to two years. The BoJ took a step further at its July meeting by saying it would slowly reduce the buying pace, aiming to halve its current monthly amount by early 2026. But the massive amount of JGB issuance needed to fund the country’s deficit means that the central bank likely won’t stop its purchases or let its balance sheet run off by not reinvesting the principal from maturing bonds, as the Federal Reserve has been doing since June 2022.  

Not surprisingly with this backdrop, JGB yields have been rising. In late August, a 30-year JGB hedged to the U.S. dollar provided a yield greater than 7%. To put that into context, the 30-year U.S. Treasury yield was roughly 4%. One would need to stretch far down the credit ratings scale to low investment-grade or even high yield to match the dollar-hedged JGB yield in the U.S. credit markets. In a world of massive debt issuance where different issues are competing for a limited amount of funds, yield matters!

Higher yields to draw Japanese domestic investors back to JGBs…

From a Japanese domestic perspective, what if modestly higher Japanese yields draw large flows back into the country in the longer run? At some point, higher Japanese yields could attract the country’s huge life insurance and pension investors back into JGBs from other high-quality government bonds, including U.S. Treasuries and German bunds. In effect, this would rearrange demand in the global market. I believe an overweight allocation to JGBs would benefit from this shift.

…and away from U.S. and German government bonds

In my view, a corresponding underweight position in U.S. Treasuries would benefit from upward pressure on Treasury yields as Japanese institutional investors move out of the U.S. and back into Japan. Other factors—including the country’s deteriorating fiscal situation and the accompanying elevated levels of new Treasury issuance—also lead me to expect higher U.S. yields on the longer-term horizon.

Faster inflation could lead to more aggressive BoJ tightening

Of course, this approach isn’t without risk. Japanese inflation could wind up higher than expected in the second half of the year in the event of continued weakness in the Japanese yen or unexpectedly strong wage growth. This could lead the BoJ to raise rates again at its October meeting and slow its asset purchases further.

Weakness in the Japanese yen could, all else being equal, lead the BoJ toward more rapid tightening. But rate cuts from other developed market central banks would offset that to some degree. Earlier in 2024, the yen hit its weakest point against the U.S. dollar since the mid-1980s and its lowest versus the euro since the introduction of the eurozone currency in 1998. But with the Fed seemingly eager to lower rates and the European Central Bank having already started to loosen policy, the BoJ won’t be under as much pressure to make Japan’s interest rates more competitive.

Shifting capital flows, dissipating tailwinds

Overall, while the yen carry trade was again a convenient explanation, my sense is that the broad market volatility on August 5 was the start of something as opposed to the end. BoJ tightening and the impact it will have on the flow of global capital is far from simple, but it will have a large influence over the next few years. However, in the context of other mega-trends such as unsustainable fiscal expansion in a number of developed countries, volatility shouldn’t be a shock—it should be more the norm.

Put a different way, there were several tailwinds that had existed for investors since the global financial crisis. Like it or not, the wind has changed, and the next few years could be tougher. The shifting global capital flows resulting from the BoJ’s tightening is one of those changes, and astute investors should be aware of the impacts.

Arif Husain Head of Fixed Income and Chief Investment Officer, Fixed Income

Arif Husain is the head of Global Fixed Income and chief investment officer of the Fixed Income Division. He is chairman of the Fixed Income Steering Committee and a member of the firm’s Management Committee. Arif is lead portfolio manager for the Global Government Bond High Quality Strategy. He is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price International Ltd.

Nov 2024 • From the Field • Article

Perspectives on securitized credit

Securitized credit market performance remained solid in the third quarter amid heavy...
By  Christopher P. Brown, Ramon de Castro, Jean-Marc Breaux
Nov 2024 • On the Horizon • Article

Finding income in high yield bonds, bank loans, and emerging markets

The non-investment-grade sectors of the bond market look the most attractive.
By  Kenneth A. Orchard

Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

Australia—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. For Wholesale Clients only.

Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.

EEA—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.

New Zealand—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. No Interests are offered to the public. Accordingly, the Interests may not, directly or indirectly, be offered, sold or delivered in New Zealand, nor may any offering document or advertisement in relation to any offer of the Interests be distributed in New Zealand, other than in circumstances where there is no contravention of the Financial Markets Conduct Act 2013.

Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.

UK—This material is issued and approved by T. Rowe Price International Ltd, Warwick Court, 5 Paternoster Square, London EC4M 7DX which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.

© 2024 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

202408-3815552