There’s Another New Carry Trade in Town

Is the Japanese yen carry trade back on? Tough question. We think it is, now that the Bank of Japan has toned down its hawkish rhetoric. More on that later. Still, even if we are wrong, the reality is that the market will be talking about the violent ructions of August 2024 for the rest of our careers. That is not hyperbole. The CBOE Volatility Index (VIX) for U.S. equities hit Lehman levels a few weeks ago. This summer’s action will be visible on long-term charts for the rest of our working days.

Even if the recent settling down of markets proves a false dawn, a new bull catalyst for East Asian equities may be forming anyway, courtesy of the suddenly also-low-yielding Chinese bond market.

Some background. After running relentlessly from Summer 2012, Japan’s Nikkei 225 took a nasty header a few weeks ago. The catalyst was a sudden repricing in relative interest rates, whereby the market concluded that U.S. rates would sink while Japanese rates would rise. That caused a sharp appreciation in the yen as attendant margin calls pushed investors to pay down the yen-denominated loans they used to buy Bitcoin, Nvidia and so on.

That action, which witnessed a larger three-day decline in the Nikkei 225 than the October 1987 action, freaked out the Bank of Japan. The central bank had painstakingly tried, apparently in futility, to prepare the market for policy tightening. After the panic, a couple of BoJ officials gave speeches to walk back their prior guidance. The yen has since stabilized.

The reader should be careful not to miss the forest for the trees. The acute pain in early August should not obscure the absolute gift that the yen carry trade delivered for the better part of 12 years. The Nikkei got running all the way back in 2012, when the Index was at 8,296. It currently stands just above 38,000 (though it was at 42,426 before the market headed south). When the bull run commenced, Japan’s 30-year bond was changing hands at 1.80%.

Remember TINA, “there is no alternative” to buying stocks when bonds yield nothing? With most countries’ bond markets taking a bath in 2022, the TINA argument lost traction in places like the U.S., where the T-note now pays 3.82%, up from an all-time low of 0.50%. The “only” TINA trade remaining is Japan’s. Or is it?

China has joined the fray.

As recently as 2019, the gap between China’s long bond yield and that of Japan was roughly four percentage points. The back-of-the-envelope math at the time: four percent yields in China, zero percent in Japan.

Fast forward to today. Japan’s bonds have been selling off since COVID-19 came on the scene, owing to the country’s economic revival. Today, the country’s 30-year bond changes hands at 2.09%. Still low, yes, and still bullish for the Nikkei. But for context, even 2% marks a generational high. China’s fortunes have gone in the other direction. A furious bond market rally has accompanied persistent economic malaise. No longer is 4% available in China’s long-term debt; it’s 2.38% now.

Go back to October 2007, when China’s stock market bubble peaked. Back then, the country was valued at 32x earnings. A value player could have said thanks but no thanks, locking in 4.24% in long bonds just before the global financial crisis. Today, MSCI China’s multiple is 11.5x, the reciprocal of which is an earnings yield just short of 9%. Call that seven points over long-term bond yields. Not a bad margin of safety for a market that has Goldman prognosticating 8% earnings growth for 2024 and 10% for 2025.