The Société Générale strategist Albert Edwards has warned that a "global financial market Armageddon" could be on the way as Japanese bond yields spike.
Long-end rates on Japanese government bonds have been rising as investors worry about inflation, government spending, and the Bank of Japan's rate hikes. Since rates in Japan have been so low for so long, the recent surge may lead to an unwinding of the yen carry trade, where investors borrow in yen at low costs and buy assets with more robust yields abroad. If investors pull their money from those assets and invest back in Japan, it could cause problems for those markets, like the US, Edwards said.
"Both the US treasury and equity markets are vulnerable, having been inflated by Japanese flows of funds (as has the dollar). And, if sharply higher JGB yields entice Japanese investors to return home, the unwinding of the carry trade could cause a loud sucking sound in US financial assets," Edwards wrote in a client note on Thursday. "Hence, I would rank trying to understand and follow the surging long end of the JGB market as the number 1 most important thing for investors at the moment."
One big factor behind the surge in Japanese yields that investors should understand is that the Bank of Japan is pulling its support in the bond market and letting its holdings roll off its balance sheet. This is because inflation has proven sticky, and the central bank no longer needs to support demand.
With the BOJ out of the market and a vast majority of Japanese bond buyers being foreign, yields are probably set to rise further, Edwards said. That could spell trouble for US stocks. It did in July and August last year, when an unexpected rate hike from the BOJ sent the S&P 500 falling 6%.
"If like us you believe BoJ QE has been pivotal to US bubble equity valuations, then the ongoing JGB rout is a game changer," Edwards wrote.
"I have always exhorted clients to keep a close eye on Japan," he said. "Major financial events often happen first in Japan, for example the late-1990s tech bubble bursting first in Japan."
