Hawkish Hint in Japan Is Just Enough to Send US Markets Spinning

(Bloomberg) — It didn’t take much to scare American investors who’ve been pushing risk assets higher for the better part of a year.

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News that Japanese policy makers are weighing a hawkish tweak to years of bond yield repression ignited a small-scale tempest across US markets Thursday. Treasury yields spiked, the yen jumped, and what had been another rousing rally in the S&P 500 quickly reversed.

Pain spread rapidly across asset classes as traders came to grips with prospects that the last major central bank to resist restrictive policy might cave. Japan markets are at the center of various international trades that exploit its rock-bottom interest rates, and bulls also worried about a repatriation of funds should those rates start to rise.

“This is an important event not only for Treasuries but also equities and credit,” said Torsten Slok, chief economist for Apollo Global Management Inc. “The fact that there is now news to tweak this policy, that is suggesting that the train is leaving the station.”

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Markets lurched after Nikkei reported that the BOJ will discuss adjusting its yield curve control policy at Friday’s meeting to allow long-term interest rates to rise above its 0.5% cap by “a certain degree.” A leadership change at the BOJ earlier this year increased speculation that the central bank may end a decade of ultra-low interest rates.

The BOJ’s public relations department didn’t immediately respond to an emailed request for comment regarding the Nikkei report made after business hours.

Much of the tension traces to the currency market, where investing playbooks have been built on the Bank of Japan’s easy monetary policies. The yen is the funding currency of choice in carry trades, in which investors borrow yen to finance purchases of higher-yielding assets.

The potential of a move away from that ultra-loose stance and the prospect of unwinding carry trades was enough to induce tremors, said Sameer Samana of the Wells Fargo Investment Institute.

“In essence, the carry trade staying in place helps investors to continue shorting the yen in their portfolios and barbelling with risk assets,” Samana said. “Not to mention, markets are incredibly stretched and don’t need much reason to take profits, which then leads to a bit of an unwind.”

Steady gains that have pushed the S&P 500 up in six of the last seven months have left equities perched at potentially vulnerable levels in terms of valuation. The benchmark index is trading for around 22 times its constituents’ earnings, almost 3 points above its 10-year median. Companies in the tech-heavy Nasdaq 100 fetch well above 30 times profits.

“Rising interest rates could negatively impact global growth and US growth — remember it’s a global bond market,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management. “Similarly higher bond yields could become a more attractive alternative for investors and pull capital away from equities.”

Prior to the Nikkei report, all economists in a Bloomberg survey predicted BOJ Governor Kazuo Ueda and his fellow board members would keep the key short-term rate at minus 0.1% at the end of their meeting Friday. More than 80% of the 50 surveyed economists also said the bank will leave the yield control mechanism unchanged.

“It all depends on what happens overnight,” said Apollo’s Slok. “It will become very critical. For the last seven years we have not seen Japanese interest rates move around with the market. Now if they decide and allow JGB yields to move with the market then nobody knows how much JGB yields could go up when we wake up Friday morning.”

–With assistance from Emily Graffeo and Carter Johnson.

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