The Great Stop Loss Risk

22 May 2025

A prescient question our friend Dave Dredge often asks Japanese policy makers is: “what if it works?”  What if inflation expectations rise on a sustainable basis reversing the post-1990 regime? If that happened, it might be challenging to anchor Japanese interest rates. The Bank of Japan could continue to purchase government bonds to “manage” the rise in yields (yield curve control). However, that might lead to a renewed episode of currency weakness. Stated differently, with government debt around 250% of GDP Japan simply cannot sustain a material rise in market interest rates. Japan is already constrained by fiscal dominance - an economic condition that occurs when a country's debt and deficit levels are sufficiently high that monetary policy ceases to be an effective tool for controlling inflation.

Japanese 30-year yields have increased by 300 basis points to 3.14% from the low in 2019 and almost 100 basis points over the last month (chart 1). That is clearly a non-trivial increase in the long-term market interest rate and a punishing mark-to-market for holders of Japanese government bonds (higher yields lead to lower bond values). The great stop loss risk is present because government bonds are collateral for the entire system. If there was a sustained rise in consumer price inflation that contributed to an unanchored rise in bond yields, the system itself could collapse. A key positive for Japan is that almost all the debt is held by domestic institutions. Systemic risk would rise if (or when) Japan required external capital.

Chart 1

Source: Bloomberg

There is also an important behavioural aspect to this episode. As we have noted in the past, long phases of stability lead to episodes of instability. The prevailing bias among most market participants is that low inflation and low interest rates were believed to be a permanent state. While the BOJ has moved away from their policy of yield curve control (a form of “peg”) the prevailing bias for several years was that interest rates would remain low and stable. That encouraged investors to take on leverage which has likely amplified volatility since mid-2024 as positions have been unwound. Put another way, several large market participants have been short convexity or volatility. The policy error in Japan and elsewhere was maintaining emergency policy measures (ZIRP, QE, YCC) for too long after inflation had persisted.

The tactical challenge in 2025 is that the United States is also experiencing an episode of unanchored inflation expectations. Last Friday the University of Michigan 1 year ahead inflation expectations survey surged to a 40-year high of 7.3% (chart 2). While that might be an emotional overreaction by consumers to the current episode, it will be challenging for the Federal Reserve to lower the funds rate in the near term. Moreover, it has likely contributed to an increase in the bond risk premium and a higher cost of capital. Recall that the US is a long rate economy, most household mortgages and corporate debt is issued at the long end of the yield curve. The “good outcome” for the United States might be a growth shock or recession that crushes inflation expectations. Ironically, that has often followed spikes in consumer inflation expectations in the past.

Chart 2

Source: Bloomberg

The implication for currencies is complex. As we often note, currencies are always a relative price. The Japanese yen is undervalued on a fundamental trade weighted basis relative to the dollar. However, the dollar continues to have superior carry on a relative rate basis. Of course, that has narrowed materially at the long end of the yield curve. Major dislocations in the Japanese Yen (and rates) have often preceded episodes on a broader cross asset basis. For example, in May 1997 the USDJPY dropped 15 big figures a few weeks before the Asian Crisis. Similarly in June 2007, the China devaluation in 2015 and the carry-unwind episode in August 2024. The Japanese Yen has often been the tip of the market iceberg. The current episode in the bond market might prove challenging for risk assets, especially given the poor risk-reward starting point.

20250522_The_Great_Stop_Loss.pdf

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