What happens when the world's cheapest, high-quality source of capital gets more expensive? Markets may find out soon.
KEY TAKEAWAYS
Japan raised its benchmark interest rate to 1.0%, the highest level since 1995. For a country that spent years operating with near-zero or negative rates, the move represents a major policy shift.
For decades, investors borrowed cheaply in yen and invested in higher-yielding assets around the world. This carry trade became an important source of liquidity supporting global markets.
Rising Japanese rates compress the profitability of carry trades. As borrowing costs rise, investors may reduce or unwind positions that were funded with cheap yen.
A stronger yen increases the incentive for Japanese capital to remain at home or return from overseas investments. Even a modest reduction in foreign investment flows can influence asset prices.
Higher energy prices and imported inflation have pushed the Bank of Japan toward tighter policy. Global geopolitical developments are now influencing monetary policy well beyond the United States.
MY HOT TAKES
The Japanese carry trade has functioned as an under appreciated source of liquidity for global financial markets for decades. Most investors benefit from its effects without recognizing its existence.
Changes in Japanese monetary policy may become increasingly important drivers of US asset prices. Market participants may be underestimating Tokyo's influence on global liquidity conditions.
The narrowing interest-rate differential between Japan and the United States represents a structural shift rather than a temporary event. The direction of travel matters more than any individual rate hike.
Energy markets, geopolitics, and central bank policy are now deeply interconnected. Inflationary shocks can transmit across borders and alter monetary decisions worldwide.
Investors often focus on domestic headlines while missing important developments abroad. Some of the most significant market-moving events may originate far from Washington or New York.
You can quote me: "The next market selloff may be blamed on the Fed, but the real cause could originate in a conference room in Japan."
Land of the rising rates. Where have you been these last thirty years? You don't have to answer that question, it was rhetorical. However if you were living in Japan you would have experienced extremely–EXTREMELY–low interest rates. Benchmark rates were actually negative from 2016 through 2024. A key reason? Inflation was a problem–not in the sense that one would expect. Japan for the most part experienced little or no inflation, and even spates of deflation, but for a spike in 2014/2015 and a brief jump in 2008.
Interest rates were for the most part consistently low, which allowed investors to borrow cheaply in Japan and invest proceeds in foreign sovereign debt that offered higher yields. Investors would pocket the differential between the low cost Japanese capital and the higher foreign return. This is referred to as a carry trade. One could almost set it and forget it and simply collect the "carry." Of course, it's not that simple–you have to factor in exchange rates, among other things–but at a high level, it was a pretty common speculative trade. It's also worth noting that one could borrow cheaply in Japan and invest in foreign stock markets. Japan's Nikkei 225 Index traded pretty much sideways for decades until the post-COVID era, which saw the index soar to where it is today, at all-time highs. You are probably thinking, "interesting Mark, thanks for the history lesson, but what does that have to do with me?" You are probably wondering why SpaceX is going up and wishing you owned some, or possibly–LIKELY–concerned about US inflation and the Fed.
My friends, here is why it matters. This morning WHILE YOU SLEPT, the Bank of Japan raised its benchmark interest rate by a quarter point to 1.0%, which is the highest level since 1995. Now, 1% doesn't sound like much. But in Japan, one percent is a generational event. And if you own US stocks, US Treasuries, or almost any risk asset that has benefited from three decades of cheap global liquidity, this is your story too. 👀 Let me explain the plumbing.
For thirty years, institutional money–hedge funds, sovereign wealth funds, trading desks– borrowed Yen at near-zero rates and put that capital to work in higher-yielding assets around the world. American technology stocks. US Treasuries. Emerging market bonds. The math was simple and seductive: borrow at essentially nothing in Tokyo, deploy the proceeds in New York or Frankfurt, and pocket the spread. It is estimated that there are roughly $500 billion in outstanding yen carry positions still floating through global markets. That is not a rounding error. That is a structural subsidy that has quietly been propping up asset prices for a generation–and most investors have no idea it exists. Did you know?
Now the cost of that funding is rising. It has been rising gradually since 2024, when the BOJ finally exited negative rate territory for the first time in eight years. Each subsequent hike–and today's move to 1.0% is the latest–compresses the spread between what it costs to borrow yen and what you can earn deploying that capital elsewhere. At some point, the math stops working. At some point, the trade unwinds.
We have already seen what that looks like. In August of 2024, a surprise BOJ rate hike triggered a violent unwind of carry trade positions. The Nikkei fell 12% in a single session. Global equities were dragged down with it. That was from 0.25% to 0.5%. We are now at 1.0%, and the BOJ's own forward guidance signals this cycle is not over. Reuters polling conducted just before today's decision showed economists expect another hike before year end, which would bring the policy rate to 1.25%. Overnight index swaps imply a high probability of another 25 basis-point hike in early Fall. There is also a critical subplot here that I want you to pay attention to: as of early June, speculative short positions on the yen by leveraged funds were the highest since November 2017, north of 115,000 contracts. The market is massively positioned one way. When that kind of crowded positioning meets a policy shift, the unwind can be sudden and severe.
Now here is where the story crosses the Pacific and lands squarely in your backyard–er, your portfolio. The yen was trading at roughly 160 per dollar heading into today's decision. Japan spent a record eleven-plus trillion yen defending its currency over the past year–roughly $73 billion–and it barely moved the needle. A stronger yen, which is the natural consequence of continued BOJ tightening, means that capital which left Japan to seek better returns abroad becomes more attractive to repatriate. Japanese institutions that have been among the largest holders of US Treasuries do not have to sell aggressively to move markets. They just have to buy a little less. The marginal buyer stepping back is often enough.
And this is where my geo-petro-politics framework enters the frame. The BOJ did not hike today because the Japanese economy is booming–in fact, the central bank revised its growth forecast lower while raising its inflation outlook. It hiked because the war, and what it has done to energy prices flowing through the Strait of Hormuz, has pushed Japanese inflation above its two percent target. Japan imports virtually all of its energy. When oil moves, Japanese consumer prices move. When Japanese consumer prices move, the BOJ has to respond. The conflict that started on February 28th of this year is not just an oil story, and it is not just an American story. It is running through the global monetary plumbing in ways that most investors are not tracking.
Moving on to a topic that you ARE thinking about: the Federal Reserve. Kevin Warsh opens his first FOMC meeting today–the very same day the BOJ made this move–and the Fed is widely expected to hold rates steady. Think about that divergence. Japan is tightening. The Fed is frozen. The interest rate gap between the two countries is compressing. That gap was the engine of the carry trade. As it narrows, the economic logic of borrowing yen to buy American assets weakens. Not overnight. Not in a straight line. But the direction is what matters, and the direction has changed.
Most average American investors don't own yen. They don't have a Bloomberg terminal. They have a brokerage account with a healthy allocation to large-cap technology and perhaps a bond ladder their advisor put together two years ago. They are not thinking about Tokyo this morning. But Tokyo is thinking about them–or rather, about the assets they own. The liquidity that has supported those valuations did not materialize out of nowhere. Some portion of it was borrowed in Japan, converted to dollars, and put to work on the same exchanges most Americans log into every morning. When that liquidity recedes–gradually, or suddenly–the average US investor will feel it without ever understanding where it came from.
My friends, the thirty-year era of free Yen is ending. Not in a single day, not with a single hike, but with the unmistakable and now irreversible direction of Japanese monetary policy. The assets that benefited most from cheap yen–leveraged technology, risk equities, anything priced on abundant global liquidity–are the most exposed to its withdrawal. I am not telling you to sell everything and move to cash. What I am telling you is that the next time your portfolio has a bad week and the headlines blame it on a Fed statement or a jobs number, there is a reasonable chance the actual cause originated in a policy meeting in Tokyo. Knowing that matters. Understanding the plumbing also matters. ありがとう Arigato–that means thank you in Japanese. 😉
YESTERDAY’S MARKETS
On Monday, the S&P 500 surged 1.65%, the Nasdaq jumped 3.07%, and the Dow added 469 points, or 0.92%, to finish at 51,671–with technology leading all sectors. The rally was fueled by President Trump's announcement of a preliminary US-Iran peace agreement, which sent WTI crude down roughly 5% to around $81 a barrel and pulled the 10-year Treasury yield lower to approximately 4.46%.
NEXT UP
Housing Starts (May) may have slipped by -2.0% after declining by -2.8% in April.
Building Permits (May) probably eased by -0.9% after jumping by 4.4% in the prior period.
The FOMC meeting starts today, but you're going to have to wait until tomorrow to find out what happened. Be patient, but don’t hesitate to wonder how many donuts and gallons of coffee will be consumed at Fed HQ today and tomorrow.