How a 25 basis point rate hike in Japan affects risk assets

Option traders are beginning to flip the script on Japan’s currency, with some of them bracing for political shocks, trade flare-ups, and shifting Federal Reserve expectations to push the yen lower against the dollar.

When Carry Trades Turn Risky 🚨 The USDJPY carry trade provides useful signals. Japan’s interest rates are near 0.25%. US rates are around 4.25%. That 4% yield gap is the reason behind this trade. Investors borrow in cheap yen and invest in higher-yielding US assets. Recently, the yen has dropped slightly due to tariff and political concerns. But here’s the risk: If the yen strengthens suddenly, these trades unwind fast. We’ve seen this before. Sudden reversals have triggered global sell-offs. 🔻 If the yen stays weak and US inflows rise too quickly, stay alert. The party can end fast when carry trades unwind.

Japan faces a critical economic juncture, marked by its 10-year government bond yield hitting a 2008 high (around 1.59%-1.60%) and the continued devaluation of the Yen against the USD. This tandem poses significant challenges for the nation's heavily indebted fiscal policies. The rising bond yield directly increases the cost of government borrowing. With Japan already shouldering the highest debt-to-GDP ratio among developed nations (exceeding 250%), this upward pressure on yields intensifies the burden of debt servicing, potentially straining public finances and limiting the government's capacity for essential investments. Simultaneously, the weakening Yen, driven by the Bank of Japan's (BOJ) historically ultra-loose monetary policy diverging from tighter global rates, inflates the cost of vital imports like energy and food. While a weaker Yen nominally aids exporters, the higher import costs contribute to domestic inflation, eroding consumer purchasing power and squeezing profit margins for many businesses. Given this precarious balance, the BOJ can no longer afford an overly passive approach. While it has initiated a cautious normalization of policy by raising short-term interest rates and tapering bond purchases, the speed and scale of these adjustments are under intense scrutiny. The current situation demands a more proactive stance to prevent spiraling government indebtedness and to address the inflationary pressures that disproportionately affect households and smaller enterprises. Failure to act decisively could lead to unsustainable fiscal policies and further economic instability. The BOJ's future actions, or lack thereof, will be paramount in determining Japan's economic trajectory. Disclaimer: This should not be read as financial advice . https://lnkd.in/gJ6hEbFG

Our latest CIO letter, which introduces our monthly Counterpoint publication, goes through Quintet Private Bank’s latest views on the US fiscal outlook and its impact on the safe-haven status of US government bonds and the dollar: 🇺🇸 A widening budget deficit and rising debt levels in the US pose a risk to US Treasuries. Therefore, we’ve decided to further reduce our US Treasury exposure and reallocate partly to Japanese government bonds and partly to US equities. 🇯🇵 The Bank of Japan looks set to raise rates as inflation has continued to rise, which we believe would lead to the yen appreciating against the dollar, supporting returns in Japanese government bonds when converted into euros. ⚖️ Despite the risk to US Treasuries, US fiscal policy stimulus is positive for US equities. Greater clarity on tariffs could support US equities in the near term, too. This is why we are reducing our tactical US equity underweight position. 💵 We think the US dollar is likely to continue to weaken. So, to protect euro portfolios, the US equities we’re buying strip out the currency effect and, therefore, aren’t impacted by a weakening dollar. You can read about this and much more in the note below. #geopolitics #economy #inflation #centralbanks #foreignexchange #markets #investing #equities #fixedincome #assetallocation #finance #wealthmanagement #privatebanking

Is China pushing back against RMB strength? It appears so but only more recently (since April). FX settlement and sales data release indicate China banks have been buying FX and reducing short FX forward positions since April. The data indicated the state banks bought USD45b of FX over the past 3 months (up till end May). See the top two charts below for details. The bottom chart is from Brad Setser, whom I follow closely as he is one of the leading experts in global trade and capital flow. Please read the following link https://lnkd.in/gVnZhEGg. However I disagree his view of drawing a close relation between growth in state banks' net foreign asset (NFA) as FX intervention. State banks' NFA growth started to pick up in mid-2024, closely tracking cross border net flows by the non-banking sector. These cross border FX inflows was mostly driven by expanding trade surplus although capital/financial accounts continued to bleed. As FX conversion ratios have remained depressed throughout (up till recently), these cross border FX inflows ends up as domestic foreign currency deposits in the banking sector which is then used to expand state banks' foreign asset (hence corresponding increase in NFA). The current landscape is somewhat frustrating for proponents of short $CNH trades. The authorities appear to continue to value stability and have been quick to push back against currency strength when FX flows into RMB are making early signs of recovery: reduced capital/financial outflows, elevated trade surplus and a pick up in exporter conversion ratio. Outflow pressure from dividend payout for Chinese companies listed in Hong Kong should also ease as they were brought forward this year to Q2 instead of the usual hefty bunching in July/August.

Something does not add up here: The Bank of Japan currently has a policy rate of 0.50% and Japan has a Debt-to-GDP ratio of 250%+. Meanwhile, Germany has a policy rate of 2.25% (4.5x higher) and a Debt-to-GDP ratio of just 62% (1/4 of Japan's). However, 30Y Government Bonds in Germany and Japan both yield ~3.2%. If you think Japanese bond yields are high, the market says we are just getting started. What is happening here?

The peg system of USD/HKD is challenged. Since May, under the wave of Asian currency appreciation driven by the New Taiwan Dollar, the USD/HKD exchange rate touched the upper bound of 7.75. In response, the Hong Kong Monetary Authority (HKMA) sold HKD129 billion to prevent further appreciation, which in turn increased the supply of Hong Kong dollars in the market. As a result, the exchange rate depreciated to the lower bound of 7.85 within a month (Figure 1). To maintain the pegged exchange rate between the Hong Kong dollar and the US dollar, the HKMA has since conducted four rounds of HKD purchases totaling approximately HKD59.1 billion to stabilize the lower limit of the exchange rate band. Although Hong Kong still holds USD400 billion in foreign exchange reserves to support the peg, this situation has posed challenges to the 40-year-long currency management regime and created numerous opportunities for risk-free arbitrage. Because of the interest rate differential between Hong Kong and the US (HIBOR fell by 4% within two months), traders can borrow low-cost Hong Kong dollars and convert them into US dollars to invest in higher-yielding markets, capturing a virtually risk-free interest rate spread. The Hong Kong government’s longstanding commitment to maintaining the currency band has historically provided investors with strong confidence, making this carry trade a nearly guaranteed profit. However, Hong Kong appears to have limited room to influence the exchange rate through interest rate policy, as doing so may further affect economic performance and an already weakening real estate market. Additionally, the US dollar could experience greater volatility because of Trump administration policies, which would increase the difficulty of maintaining the currency band and lead to more frequent government interventions. Alternative proposals have been raised to replace the USD peg, including switching to a currency basket to increase stability or pegging to the Renminbi (RMB), given its close economic ties with Hong Kong. However, the former would reduce monetary policy transparency and complicate management, while the latter, though attractive, may have its advantages offset by China’s capital controls despite lower transaction costs. Other suggestions such as widening the exchange rate band or returning to the gold standard have also been considered, though none may necessarily offer a better solution than the current system. The Hong Kong government’s next moves will therefore warrant close attention. Figure 1: USD/HKD Exchange Rate, Bloomberg

Japan’s Bond Market Is Flashing Red — And It’s a Global Warning Sign by Martin Pelletier, CFA In 2008, Japan was the quiet stabilizer. In 2025, it may be the first advanced economy to lose control of its sovereign bond market. Yields on Japanese government bonds are surging. The yen is collapsing. And the Bank of Japan is no longer steering the ship—markets are. With Japan holding over $1.13 trillion in U.S. Treasuries, the ripple effects could hit American debt markets hard. This isn’t just about Japan. It’s about the end of the Modern Monetary Theory era. It’s about rising political risk in the U.S. and the potential erosion of confidence in the Fed. 📉 What should investors do? 1. Watch the bond market—it’s the new early warning system. 2. Rethink the 60/40 portfolio—bonds may no longer offer protection. 3. Diversify globally—especially with U.S. equity concentration at record highs. The quiet anchor of global finance may be slipping. Are you ready for what comes next? https://lnkd.in/gS4k6cA8 #Investing #Markets #Japan #Bonds #PortfolioStrategy #GlobalFinance #RiskManagement

While it hasn’t been openly discussed, I strongly believe a central but hidden objective of these trade agreements is to intentionally push the US dollar lower relative to other major fiat currencies. One possible lever to support that effort could be Japan allowing its long-term interest rates to rise relative to US yields. Keep in mind, only about one-tenth of Japan’s debt is tied to maturities of 20 years or longer. It also wouldn’t surprise me if a large portion of the $550 billion capital commitment Japan recently announced — without specifying a timeline — ultimately comes in the form of Treasury purchases, helping to drive US yields lower. Although already the largest holder, Japan’s Treasury holdings have remained virtually unchanged for over a decade. For the record, I don’t believe this is just about Japan or the yen. Even after its worst year-to-date performance since the 1970s, the US dollar remains significantly overvalued by historical standards — and a meaningful decline is likely a necessary adjustment to help correct the severe trade imbalance the US currently faces.

Plotting a Dollar Decline? Markets Didn’t Get the Memo The concerns expressed in the note reflect a public narrative around trade imbalances and currency adjustments, though the ‘hidden objective to push US Dollar lower to other major currencies’ warrant clarification. The $550 billion Japanese “Capital Commitment” is not an investment -- and certainly not a market mover The recently announced $550 billion Japanese capital commitment even if one were to assume – counterfactually -- that this amount would be spend entirely on U.S. long-term Treasury purchases, it would be negligible in market terms: the approximate daily turnover of 30-year U.S. Treasuries alone exceeds $300 -- 400 billion, based on SIFMA and FICC data. This makes the entire $550B figure equivalent to just 1.5 days of long-bond trading volume, hardly enough to move markets, let alone engineer strategic currency shifts. The notion of an “Overvalued Dollar” needs to be put in context The idea that the dollar is “significantly overvalued by historical standards” has to be specified against a proper benchmark. If we examine USD Real Effective Exchange Rate (REER) and Nominal Effective Exchange Rate (NEER) indices over the past five years until now, there is no evidence of calamitous overvaluation or disorderly depreciation. The U.S. is not a developing country -- trade imbalances are not attempted to be fixed through FX depreciation The claim that a “meaningful decline” in the dollar is a necessary adjustment to correct U.S. trade imbalances reflects a framework more appropriate to emerging markets with limited monetary autonomy. The U.S., as the issuer of the world’s primary reserve currency, adjusts its trade and capital account imbalances through multiple refined channels, including global dollar seigniorage, foreign investment flows, global demand for Treasuries, and the dollar's role in commodity pricing and global reserves. The U.S. does not need to rely on currency depreciation to restore external balance. In fact, a forced dollar depreciation would risk destabilising global financial markets, many of which are dollar-invoiced or dollar-indebted.