Japan Just Broke a 30-Year Relationship

Japan’s 10-year bond yield just hit 3% for the first time since 1996.

At the same time, the Yen is trading near its weakest level in four decades…

Those two things aren’t supposed to coexist forever (all else equal, higher yields should lead to stronger currencies.)

So why hasn’t the Yen Strengthened?

Simply put,

Japanese capital had very little reason to stay home for the past couple of decades.

Bonds paid almost nothing (less than 1%.)

U.S. Treasuries paid 3-4% and sometimes more.

Banks and other large institutions got a free ride off Japan’s cheap money base, which worked beautifully until inflation, de-globalization, and tariffs became a problem.

That problem completely changed the economics of the carry trade as follows:

At first glance, the math still works.

But,

There’s no such thing as a free lunch in financial markets, so the people responsible for upkeeping this trillion-dollar machine have to get compensated for the risk that it eventually breaks.

Today, it’s starting to break.

Hedging the carry trade risks (compensation) costs closer to 3.7% today.

That 4.8% U.S. Treasury?

It yields closer to 1.1% after that hedge cost is baked in.

Against a 3% net yield for domestic Japanese investors.

In other words,

Japanese institutions can make over 2% more investing at home than buying the hedged Treasuries in the carry trade.

At today’s levels, the U.S. 10-year bond would have to pay roughly 6.7% just to compete with a 3% Japanese 10-year bond.

Not a forecast, just the current economics.

Scott Bessent is trying to keep this from collapsing, which is why USDJPY interventions have been so frequent as of late.

But the market’s message is clear…

They are buying Yen and selling Dollars because it now makes more sense to invest in Japan than it does in the United States.

Bonds confirm it, Forex reinforces it…

Now it’s time for equities to join the game.

Today, we’ll go over the specific mechanics behind the carry trade, whether we are at extremes or have a bit longer for this to play out.

And most importantly,

Which industries in Japan are ripe with opportunities for us to create one of my favorite trades of all:

Let’s get into it,

Japan Just Broke a 30-year Relationship.

Let’s make the mechanics here a little easier to understand, because it is the main driver behind the capital flows between the United States and Japan.

Right now, according to all the moving parts that affect the carry trade, the overall benefit goes to Japan.

Without question:

A no brainer in terms of where Japanese capital will want to flow next.

Especially when you consider what’s happening around the world in terms of the AI race and concentration around U.S. equities.

Japan is one of the biggest players in AI equipment manufacturing, as is South Korea.

They also export a large amount of electronics, automobiles, and machinery to the United States:

Let me paint a picture off of this now.

The United States clearly has a supply problem around the three biggest exports that Japan offers.

Rising bond yields in Japan will eventually make the Yen stronger, making these exports (on top of tariffs) a lot more expensive for the United States to bring in.

That’s one reason why Scott Bessent has intervened so much on the currency, helping Japan avoid further Yen weakness by manipulating their currency and keep U.S. buying power stable for these required electronics and equipment machinery.

Just like his attempts to keep the U.S. Treasury yields lower, I believe this will fail miserably.

So, while most will tell you to look to Japanese electronics and AI-related exports, I don’t think this is where the real alpha will be.

I think it’ll be in the country’s largest export category:

When you look at the current price action in Japan’s biggest automakers like Toyota Motors (TM) and Honda (HMC)…

Things start to clear up in terms of what the market wants to reward in a forward-looking sense:

There’s a reason these two ordinary companies have outperformed most U.S. stocks on a year-to-date basis.

It’s because the market is already rewarding companies that benefit from a weaker Yen.

Weaker Yen = More Export Volumes.

This is where we begin to drill down into the industries to consider in a potential peak and turn of the carry trade rotation.

Because there are a lot of moving pieces here, let’s recap:

That’s exactly why the market has anticipated the gains to be had in multi-national exporters like Toyota and Honda.

Here is a list of industries most exposed (in beta terms) to changes in the USD/JPY rate:

Bingo, we have autos with a high U.S. mix as the most exposed.

Which makes sense as you see Nissan, Subaru, Mazda as some of the laggards in this trade significantly underperforming the diversification in Toyota and Honda.

The reason?

USD/JPY hasn’t yet moved, and the Fed hasn’t acted yet on rates to make this happen.

This introduces timing uncertainty, which I sought to fix by spreading two very important ETFs:

Simply put,

You want to hold DXJ when the Yen weakens, and EWJ when the Yen strengthens.

Here’s how that spread is trading today:

As the Yen has weakened since 2021, the DXJ (the exporters) have outperformed the domestic names massively.

To the tune of almost 4x.

With this extreme outperformance comes a two-path trade to consider in the works:

This still hits the autos the most as seen in our USDJPY regressions.

Though this reversal will now be bearish for Toyota and Honda, and bullish for those with a larger U.S. mix like Mazda and Subaru.

Here is my current dashboard to gauge the timing of this potential turn into a stronger Yen.

Seems like most measures are beyond historical extremes, supporting the view that risk/reward ratios are shifting in favor of the EWJ rather than the DXJ.

Recall, this includes those names with a relatively strong U.S. presence.

Which directly ties into our view of the U.S. consumer now being a coiled spring.

While it would be beneficial for the U.S. to continue to see a weakening Yen in terms of being able to import cheaper electrical equipment and AI machinery,

Market mechanics, like the capital rotation, could soon favor a stronger Yen instead.

When this happens?

Most importantly, watch for the following capital flight OUT of the U.S.

We now estimate that Japan holds ~$1.13 trillion worth of U.S. Treasuries, and $800 billion worth of U.S. equities.

If the more attractive domestic investments in Japan trigger this massive rotation, you will begin to see it in further U.S. bond weakness (already sort of happening.)

More importantly though,

You will see it in equities like you saw it in South Korea.

Most of this equity exposure is centered on mega-cap technology names, think AI-related players.

The second largest concentration is in large-caps outside of AI.

Here’s what I’m thinking:

Working on that now.

But, the actual trade will be reserved for Offside Premium members only.

Let’s now consider what the market thinks of DXJ and EWJ in this Yen rotation.

Remember, a stronger Yen should lead people to buy EWJ instead of DXJ.

Here’s what the options market has to say:

EWJ has roughly 20x the amount of calls going near the money ($100 strike) compared to DXJ, who only has ~200 call options open for a $205 strike.

On the put side, DXJ has twice the amount of out the money puts at $135 strike compared to calls.

EWJ has roughly 17k put options opened at $89, which in my view could be financing the long calls we just mentioned above.

All told, these strikes and betting interest tell me the downside in DXJ is perceived as much larger compared to the downside in EWJ, the opposite is true for upside.

Do with this information what you will.

$2/day, and your portfolio could also have some of our institutional-grade trade ideas running for you.

Show me a better ROI.

Meanwhile, check out Goldman Sachs’ latest view on the data center buildout, keep some notes handy as we go into the PMIs later this week to prove whether we’re still at a healthy state of affairs.

Or whether a big reckoning is about to hit us:

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.