Is the Yen Carry Trade Spiking Global Yields?

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There’s a theory going around that an unwind of the Yen carry trade is what’s behind the recent spike in long-term government bond yields globally. This theory is part of a larger conversation about what’s driving the rise in yields. On one side is a camp that tells a benign story whereby yields are rising mainly because of the war with Iran and higher oil prices, which is causing central banks globally to shift hawkish and pushing up yields across the curve. On the other side are people like me who think something more ominous is going on, with markets increasingly fearful that fiscal policy is out of control so that risk premia embedded in longer-term yields are rising.

These two camps aren’t mutually exclusive. The opposite is true. Rising geopolitical risk - which is what higher oil prices are about - is making markets more attuned to the fact that fiscal policy is a mess in most countries. That said, the Yen carry trade theory belongs in the first camp because it’s a story about an exogenous shock that goes in the direction of absolving fiscal laxity. After all, why point the finger at US fiscal policy when rising Treasury yields stem from Mrs. Watanabe’s mood swings?

Japan has terrific data on portfolio outflows, so we can trace exactly whether the recent rise in long-term Treasury yields correlates with a pullback in Japanese flows into long-term US debt. The black line in the chart above is plotted on the left axis and is the 12-month rolling average for Japanese portfolio flows into longer-term US debt. The blue line is the 10-year Treasury yield and is plotted in inverted scale on the right axis. There’s a decent historical mapping between the two. When the carry trade is strong, i.e. when the black line is at high levels, the 10-year Treasury yield tends to be lower. When the carry trade is weak, i.e. when the black line is low, US yields tend to be higher. However, the recent sharp spike in 10-year yield does NOT map into a commensurate deterioration in Japanese flows. If anything, they’ve been stable at a weak level. The bottom line is that the Japanese carry trade doesn’t look like it has much to do with the spike in US yields. Let’s leave Mrs. Watanabe out of this.

It’s actually kind of weird to focus on the Yen carry trade as the driver of rising US yields. The black line in the chart above is overall US debt issuance, while the bars of different colors are sources of demand for all the Treasuries getting issued. If you’re focused on the Yen carry trade, you’re focused on one subset of the purple bars, which are foreign demand for Treasuries. As the chart shows, there’s endless other buyers who might be the reason why Treasury yields are spiking, not to mention the fact that issuance is now running at 7.5 percent of GDP over the past year. I think we can leave Mrs. Watanabe out of this one. We’re just running really irresponsible fiscal policy at a time when geopolitical uncertainty is high. That’s why yields are rising.