Do You Recognize This Crisis Center?

Dear Reader,

Tokyo, Japan is about 7,500 miles from my house.

Population: 14 million.

That’s nearly two thirds the population of my state packed into this massive city.

Normally, I’d be focused on the Nippon Professional Baseball Organization, which has produced some of the top talent in Major League Baseball… Players like Shohei Ohtani. I follow two players on the Japanese World Baseball Classic team – and I expect they’ll be in starting lineups stateside very soon.

But that’s not what I’m watching today.

I’ve been paying very close attention to a company called the Fukoku Mutual Life Insurance Company. Bear with me…

They’re a big Japanese life insurance company, part of an institutional ecosystem that has been buying and holding U.S. Treasury bonds for years.

Over the last decade, the Bank of Japan (the nation’s central bank) has been the most aggressive in keeping interest rates low and consistently boosting its balance sheet.

The result has been a dramatic downturn in yields on the domestic front. So, Japanese companies have been turning to the U.S. and European treasury markets for any consistent yield.

But times have changed. And this month, Fukoku Mutual Life Insurance announced its intentions to start selling U.S. bonds at a frantic pace.

Is this the source of a serious crisis?

How Japan Fits Into U.S. Bond Problems

Here’s the justification of Japanese bondholders and U.S. debt:

Japanese traders took part in a long-term carry trade that allowed buyers to make money on the spread between the U.S. 10-year bonds (and other national bonds) and the Japanese 30-year bonds. This went on and on for quite some time.

But then things went off the rails. COVID-19 hit. The U.S. started printing massive amounts of money. The Fed hiked its balance sheet at a breakneck pace… and then inflation started.

With higher inflation, came higher interest rates.

And with higher interest rates came higher U.S. Treasury Yields.

And with higher Treasury Yields came a decline in the value of bonds for existing holders.

Remember, the current banking crisis centered on financial companies that were holding low-yield bonds, but saw their values plunge to the point that the banks were insolvent on paper.

Well, that very same phenomenon has impacted that carry trade for Japanese holders of U.S. debt. The result has been a dramatic amount of lost money and lost opportunity.

Bloomberg notes that the U.S. 10-year bond might pay 3.6%. However, the new hedging cost for these Japanese bondholders is leading to returns of -5%.

A lot of Japanese institutions are looking at their own domestic debt as a better alternative.

But there’s another catalyst at play.

And this could completely shakeup the global financial system.

Under New Management

Today, the Bank of Japan held its first meeting under its new Governor, Kazuo Ueda.

Before this meeting, Fukoku said it would sell about $65 billion in currency-hedged foreign debt holdings (hello, U.S. and European debt).

As I noted, the BoJ has kept its policy loose for about a decade. During the run up to this meeting, its leaders have said it doesn’t plan to change its course on monetary policy.

The problem is that many people don’t believe this. Over the last four months of 2023, Japan’s inflation levels increased above 3%, topping at 4.3% in January 2023.

Back in December, most people didn’t notice that the Bank of Japan had decided to ease its “yield curve control.”

This would double its long-term borrowing costs, showing the world that the Bank of Japan might eventually stop dumping money from the sky.

If the bank does change course, cuts its balance sheet, and starts to raise interest rates – even by a meager amount – it would impact that carry trade even further for all those institutions. More so, it would likely attract a flow of capital out of the U.S. bond markets and into the Japan’s.

This could be rather substantial. If Japan is reducing its total amount of exposure to U.S. debt – while other nations do, then what happens next?

There could be deep concerns about liquidity for U.S. Treasury Bonds. And with that comes a lot of speculation about whether the Federal Reserve would need to step in – yet again – as the buyer of last resort and provide enough liquidity to the system.

There are risks everywhere – you simply need to know how to spot them. We could be on the cusp of a great shift in the state of the U.S. markets.

If the Fed pivots and starts buying more assets, that’s bullish. Thats’s just the way this whole thing works.

Liquidity matters. The Fed matters. And the market is very disconnected from the underlying economy due to a 25-year sugar rush.

To your wealth,

Garrett Baldwin

*This is for informational and educational purposes only. There is an inherent risk in trading, so trade at your own risk.

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*This is for informational and educational purposes only. There is inherent risk in trading, so trade at your own risk.

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