Bank of Japan (BOJ) changed the game for debt and currency markets on Tuesday by raising its benchmark 10-year bond yield target to 0.50%, up from the previous mark of 0.25%.
The surprise BOJ move sent shockwaves throughout the global financial markets, adding to the volatility seen following a hike in the U.S. and European interest rates last week.
For nearly two decades, BOJ has kept the benchmark bond yields to zero and negative territory to help the Japanese economy stay afloat following the bust of a multi-asset bubble.
But, unfortunately, it resulted in a prolonged stag deflation of near-zero economic growth and near-zero or negative inflation.
The situation changed in recent months, as inflation spread worldwide and began to appear in Japan, averaging 1.99% for 2022.
And that forced BOJ to join its U.S. and European counterparts to hike rates and bring them back to positive territory, narrowing the spread between domestic and overseas rates.
While the spread remains wide in favor of foreign rates, it makes the yen carry trade — a situation where traders borrow yen funds and invest them in overseas assets — less appealing.
The immediate impact was evident in currency markets where the yen rallied against major currencies. For instance, at 9.30 am, the dollar was buying 132 yen, down from 137 yen a day early. The euro was buying 140 yen, down from 145 yen earlier.
It was also evident in the debt markets, with the 10-year U.S Treasury bond yields spiking 3% in late morning trade.
Japanese traders and investors have been on the top of the list of foreign buyers of U.S. Treasuries, in essence, financing the country’s debt and cushioning bond yields even in the face of reverse Quantitative Easing, the selling of Treasuries by the Fed.
Meanwhile, equity markets had difficulty figuring out how BOJ’s movement affects equity valuations. On the one side, a stronger yen/lower dollar is a good thing for equity valuations, as it boosts the value of revenues and earnings listed companies derive from selling to the Japanese market.
On the other side, the higher bond yields make equities less appealing, as these yields are a critical discounting factor in most valuation models. Thus, the volatility seen in major U.S. equity averages during the trading day.
Overall, the sharp rise in the yen has the potential of turning into a Black Swan event, as traders and investors rush to unwind the yen carry trade positions they have in their books. It happened before with the collapse of long-term capital, and it will happen again if it turns out that these positions are too large to unload in an orderly fashion.
Wall Street should be watching closely.
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