The FX Trader: Japanese bond sell-off ramps up pressure on JPY.

What to know

Crisis time for Japan’s bond market: a massive rush higher in Japan’s yields as election set for February 8. Japan’s yields were already on the rise Monday on the confirmation that PM Takaichi would call new elections, but then we saw a wild acceleration in the Tuesday session in Tokyo, with long bonds selling off and the 30-year benchmark JGB yield, for example, ripping another 25+ basis points higher to a new record high since the bond was introduced at 3.875%. The 10-year benchmark JGB yield rose another eight basis points Tuesday to its own modern record (since the late 19990’s) above 2.3%. The snap election announcement (intended to take advantage of LDP leader Takaichi’s personal popularity) came with promises to roll back sales tax on food, which would cost on the order of another 0.6% or more of GDP.

This move in Japan’s government bond market is taking on Truss-esque levels of severity as the slow collapse in JGB’s and the yen now risks becoming an avalanche. The snap election move could backfire. Policy options are not attractive for solving the problem: fiscal austerity is a non-starter as it would crimp nominal growth, the BoJ strong-arming the yield curve with yield caps or yield-curve-control just transmits the pressure to the currency, and rate hikes are not helpful either, though interesting that almost no chance of a rate hike is priced until the April or June BoJ meetings. Some form of FX intervention plus “capital controls lite” plus shifts in issuance patterns and even a “twist” in the BoJ’s holdings to increase holdings of now much cheaper long JGB’s is a possible eventual policy mix.

Market churning with uncertainty – Fed Chair drama and new US-EU trade and geopolitical showdown over Greenland. Last Friday saw the US dollar ending the week with a flourish of strength after US President Trump said he thought White House economic adviser Kevin Hassett should stay where he is rather than his nominating Hassett to replace Chair Powell at the Fed in May. Widely considered the dovish odds-on favourite to become the next Chair, US treasury yields jolted higher (note key move in US 10-year treasury benchmark yield on Friday and close at 4.22%, which is above the well defined area that was capped by 4.20% since last September – the pressure on US Treasuries picked up further in Tuesday’s Asian session on contagion from JGB’s.). The US dollar saw an additional little lurch higher as well.

Later, the dollar weakened Monday and further (ex USDJPY) to start Tuesday in Asia after deciding that Trump’s continued escalation on demanding to take or “buy” Greenland risks a new stand-off over trade and even the entire trans-Atlantic alliance. Trump has threatened an additional 10% tariffs against 10 EU countries on Feb 1, to rise to 25% on Jun 1 if a plan doesn’t move forward on the US acquiring Greenland. The US dollar is not serving as a safe haven on this latest spat, perhaps as Trump’s aggression here is seen as deepening concern about foreign portfolios’ exposures to US assets. European investors have trillions of USD in US treasuries and equities.

This looks more worrisome than prior rounds of tension because if feels like the escalation path this time could prove comprehensive if both sides stick to their guns. Does he or does he note “TACO”, possibly as soon as this Wednesday-Thursday at the Davos WEF conference?

If this showdown deepens, the market hasn’t even begun pricing in the risks. The escalation path is comprehensive and ugly if that’s where we end up. On trade and markets, the EU can take down the US equity market, especially the Mag7 by escalating with its “Anti-Coercion Instrument” (or ACI, ironically designed to confront China if needed) which could see it go after the largest US giants beside the usual risk of retaliatory tariffs and a general rotation out of US equities. The US could theoretically escalate with threats to cut off key exports like Nvidia chips or even LNG deliveries to Europe, which represent some one-half of the overall imports of LNG and around a quarter of overall gas supply in Europe. That all sounds far too extreme – let’s hope we don’t go there. If we do, I would lean on USD down as the biggest risk – the view for euro a bit difficult on an ugly escalation. At the moment, it is serving as an awkward safe haven between the US dollar and the even weaker Japanese yen.

Chart focus: EURJPY
EURJPY is having another go at the highs of the cycle on the combination of the euro rising on the US-EU showdown and the JPY struggling as long bonds have been sent spiraling Liz Truss-like into a deepening sell-off. The two-way volatility could pick up significantly from here as we move toward 1) a showdown or a come-down from the US-European confrontation over Greenland and 2) an incoming policy move from Japanese officialdom to contend with both spiraling yields and the weak Japanese yen, if possibly only after the situation worsens further.