The market opened this week with a clear divergence. Falling European bond yields provided some relief to the stock market, with the Stoxx 600 index holding above its 50-day moving average. However, US stock indices failed to maintain their previous optimism, returning to caution after Washington quickly denied reports of sanctions waivers. This morning, the market situation shifted again: yields climbed, putting pressure on stocks. The yield on Japan's 10-year government bonds, nearing the 2.80% mark, became the core focus of market attention.



Rising oil prices have further exacerbated inflationary pressures. In addition, Japan's economy grew at an annualized rate of over 2% in the first quarter, with consumption exceeding market expectations and price pressures showing no significant easing. These data have collectively increased market expectations for a Bank of Japan (BoJ) interest rate hike, and this expectation has been directly transmitted to US Treasury yields.

Japanese yields have global implications: a direct correlation between Japanese and US Treasury yields.

Swissquote Bank stated in its report: "Japanese yields are a matter of global importance." As one of the largest foreign holders of US Treasury bonds, Japanese pension funds, insurance companies, and other institutions have been continuously increasing their holdings of US Treasuries for many years. The core reason is that "Japanese domestic yields have been at extremely low levels for a long time—often close to zero interest rates—which makes US Treasuries significantly more attractive."

This investment model once provided ample liquidity to global markets: Japanese investors borrowed cheap yen, allocated it to high-yield overseas assets, and earned interest rate differentials. However, this logic is now reversing. The report explicitly states: "If the yield on 10-year Japanese government bonds (JGB) rises to the 1.75%-1.77% range, domestic bonds will become attractive to large Japanese institutions: they can obtain substantial returns domestically without bearing the exchange rate risk, hedging costs, and overseas exposure risks associated with holding US Treasury bonds."

Currently, the yield on Japanese 10-year government bonds has significantly broken through this key threshold and continues to push towards 2.80%. Even if Japanese institutions only repatriate a portion of their overseas funds, it will weaken demand for US Treasuries, thereby directly pushing up US Treasury yields. This week, the yield on US 10-year Treasury bonds broke through 4.60%, reaching a new high in a year. At the same time, other holders of US Treasuries, such as China, are also adjusting their asset allocations, further exacerbating the selling pressure on US Treasuries.

Risks of reverse arbitrage trading: It may shift from temporary to more persistent.

The continued rise in Japanese government bond yields is increasing the risks of "reverse carry trades." As Japanese funds flow back to Japan, US Treasury yields are rising, and bond yields worldwide are climbing in tandem. Higher yields will suppress stock valuations. A typical example occurred in August 2024 after the Bank of Japan raised interest rates, when the Nikkei index fell nearly 20% within days, and the Nasdaq index fell by about 14%.

The key identifying signal of this risk is a sharp decline in the USD/JPY exchange rate, coupled with a risk-averse resonance between the stock market and yields. Currently, the yield on 10-year Japanese government bonds has been able to remain stable at a higher level, and Japan is gradually emerging from a two-decade-long deflationary cycle. This means that capital inflows are likely to exhibit structural characteristics rather than short-term fluctuations.

There's no need to worry excessively: the hedging capabilities of global central banks

Regarding the aforementioned market changes, Swissquote analysts stated, "I am not particularly concerned about the impact of Japan's liquidity tightening. I believe the Federal Reserve and other major central banks have the capacity to fill the gap through quantitative easing (QE), repurchase facilities, or other liquidity support programs." This view is worth investors' close attention.

For many years, Japan's capital outflows have been a significant driver of the global low-interest-rate environment and rising asset prices. A sustained repatriation of Japanese funds would indeed reduce potential demand for global risk assets and push up overall borrowing costs. The report argues that major central banks, such as the Federal Reserve, possess sophisticated policy tools: they can restart quantitative easing to directly purchase assets, inject short-term liquidity through repurchase agreements, or design targeted programs to quickly fill gaps when necessary. These measures have effectively offset similar liquidity disruptions on numerous occasions in the past, preventing the spread of systemic risk.

This is why, despite the Japanese 10-year government bond yield repeatedly breaking through the key threshold of 1.75%-1.77%, the market did not experience the expected sharp collapse. On the contrary, global liquidity generally remained on an upward trend, with most funds ultimately flowing into the stock market and other risky assets. This is also the underlying logic behind the report's advice to investors to "remain calm and continue holding positions": supported by the hedging capabilities of global central banks, stock price inflation still has a basis for continuation.

While newly appointed Federal Reserve Chairman Kevin Warsh has expressed a willingness to shrink the balance sheet and achieve balance through interest rate cuts, liquidity support tools will most likely remain the primary option in practice.

Recent yield trends to watch

The Bank of Japan meeting on June 16-17 is a key juncture for the market. If the Bank of Japan raises interest rates to 1.00%, the yield on 10-year Japanese government bonds may fluctuate at high levels, while the yield on 10-year US Treasury bonds will continue to face upward pressure, potentially testing the 4.7%-4.9% range. A significant decline in the USD/JPY exchange rate would further validate the deepening of reverse carry trades.

In the short term, yield fluctuations will be mainly driven by the implementation of the Bank of Japan's policies and the verification of related economic data, while the hedging expectations of global central banks will limit the extreme upside potential of yields.

Key takeaways for investors

Close monitoring of the yield on 10-year Japanese government bonds (especially when it's above 2.75%), the trend of 10-year US Treasury bonds, and the USD/JPY exchange rate is necessary. Currently, a structural shift is underway in the market, but the central bank's ability to "fill the liquidity gap" provides an important buffer. Maintaining disciplined asset allocation during market corrections remains a core investment principle worth considering in the current market environment.