As if the US sovereign bond market needed any more stress after Kevin Warsh’s appointment as the new chair of the Federal Reserve, fears of the unwinding of the yen carry trade are reigniting. Bond yields are already feeling the pressure, and the consequences for US assets and the macro environment could be long term.
The 30-year US Treasury bond yield, regarded as particularly sensitive to political risks, rose to 5.19% on May 19, the highest since 1999. Japanese 30-year yields reached 4.162% by May 19, also the highest level since 1999. Meanwhile, UK 30-year gilts peaked at 5.85% on May 18 before falling back slightly.
Oil prices are a key factor in this dynamic as they push inflation higher, necessitating central bank rate hikes. Crude oil prices breached the US$100 threshold once again on May 18 with Brent crude reaching $112.10 per barrel.
All these inflationary factors make central bank rate cuts unlikely in the near term, although rate hikes are also thought unlikely by most commentators. Market observers also expect oil prices to stay high even if a Middle East peace deal is reached.
With domestic bond yields so high, Japanese investors and institutions have less and less incentive to invest abroad, especially with currency risk factored in. Never mind the increased perceived risk of US exposure, which has made both Japan and China retreat from their historic high US Treasury positions.
When Japanese investors exit US Treasuries, US yields rise, fuelling a vicious circle. Higher US yields tend both to pull up other yields worldwide, and to pressure equities. Given peaky US equity valuations, this adds one more risk of a correction that the global market does not need.
Bond markets rather than central banks govern the rates at which private market players can borrow, so consumers and companies alike face more expensive debt, implying recessionary pressures worldwide. Developed economy governments, meanwhile, are already heavily indebted and face higher repayment costs, constraining their room for higher spending.
The Fed does have room to inject more liquidity into the system to offset lost Japanese investment capital. The question is, whether this would be enough to offset the recessionary consequences of current developments.
In any event, the yen carry trade looks likely to go the way of the cheap money era, another entry for the macroeconomic history books. Investors and markets had best be prepared.
