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WeekWatch
Stock Take
When the governor of the Bank of Japan (BoJ) speaks, he moves markets. His comments about a possible further rise in Japanese interest rates caused bond yields to rise (and their prices to fall) in the US and UK, and global stock markets to decline.
Why do prospects of higher Japanese interest rates unnerve global markets?
Why investors loved Japan’s negative interest rates
For years the Japanese economy, the fourth largest in the world, struggled with low domestic consumer confidence and weak demand. Over time, this has led to falling prices, known as deflation. The BoJ tried to reverse this by cutting interest rates. It hoped domestic consumers would get out and spend on goods and services rather than see their savings continue to lose value.
Overseas investors took advantage of this low, sometimes negative, interest rate environment. They borrowed yen, converting it into US dollars or euros, and bought higher yielding assets overseas, such as US Treasuries, delivering returns of 3%-4%, as well as shares.
This relatively low-risk investing strategy is known as the yen carry trade. Comparable to using a cheap Japanese mortgage to buy a more expensive rental yield property in the UK or US, it proved popular with international investors.
Carry trade unwinds in 2024
For the first time in 17 years, the BoJ finally raised interest rates in early 2024. A more substantial rate hike followed in August that year, resulting in a double-digit percentage sell-off for the Nikkei index. Higher interest rates meant that overseas investors had to quickly pay off their now more expensive yen loans by selling some of their carry trade investments, causing these prices to fall. At the same time, higher rates pushed up the value of the yen, making it more difficult for Japanese exporters, whose products became more expensive overseas.
Martin Hennecke, head of SJP’s Asia & Middle East Investment Advisory says: “The sharp rise in the yields of Japanese government bonds (JGBs) in a relatively short period of time serves as a reminder of the risk of using leverage when investing, with the yen being one of the most popular carry trade currencies.
“Any advice on the use of leveraged strategies can be conflicted as it often results in large amounts invested. This in turn can often backfire badly in an adverse scenario. Investors enticed into this type of strategy by high future return projections based on ‘historical evidence’ should tread very carefully. Financial markets can be more unpredictable than we would like to think.”
History doesn’t repeat, but it rhymes
Early in the week, global bond and share markets sold off following the possibility of higher Japanese interest rates. 10-year JGB yields are now at their highest level since mid-2008. Japanese investors in US bonds are more tempted to sell their US Treasuries and repatriate these funds to purchase JGBs.
This matters because Japanese investors are the largest buyers of US Treasuries. If they make fewer purchases, the price of US Treasuries falls, while its yield rises to compensate. This is not good news for the US federal government, which is forced to pay a higher interest rate on the debt that it regularly re-finances. Its own figures forecast interest payments will be $1.2 trillion in 2025 on the national debt of $37.6 trillion. All sides agree this is an unsustainable path, yet it continues to rise.
Market round up
Despite the weak start to the week following the BoJ comments, US stock markets ended the period higher, with the S&P 500 less than 1% below its record closing high. Leading technology companies, also known as the Magnificent 7, outperformed the remaining S&P 493. Apart from the continuing upbeat investor sentiment towards AI, a further catalyst is the expectation of a 0.25% rate cut by the US central bank this Wednesday, with hopes of more to come in 2026. Interest rate sensitive sectors and smaller companies, which often have higher levels of debt, will be key beneficiaries.
The US dollar eased on the prospect of lower interest rates. This makes gold, which is priced in dollars, cheaper for buyers using other currencies such as the euro or yen. Gold closed about 4% below its recent record high.
Elsewhere, shares in Europe ended higher. In Asia, Japanese shares rallied following Monday’s weakness and closed up almost 1%. Shares in China also rose, where sentiment is underpinned by technology and AI themes.
Wealth Check
Thousands of households are facing hefty inheritance tax (IHT) bills after falling foul of the seven-year rule on gifting, a freedom of information request has revealed.
HMRC is asking more than 14,000 families to pay tax due after receiving gifts from relatives who died within seven years of leaving their assets. These range in size, with some families facing tax bills of millions of pounds.
Any gifts over the £3,000 annual gift allowance become part of the person’s estate, leaving the recipient potentially liable to pay inheritance tax on them. The IHT levied on gifts is charged on a sliding scale, depending on when the person died. If a person dies more than seven years after making the gift, then no tax is due.
Currently it is possible for people to leave an estate worth up to £325,000 without the recipients having to pay IHT. This is known as the nil-rate band. This increases to £500,000 if property is left to a direct descendant and the estate is worth less than £2 million.
From April 2027, people’s pension pots will also become part of their estate and therefore fall into the IHT umbrella. This is likely to push more estates over the tax thresholds, leaving more families and individuals facing a tax bill.
HMRC has seen an uptick in gross IHT receipts in recent years, as higher inflation has pushed up asset prices. Between April and October this year, IHT receipts were £5.2 billion, up £0.2 billion compared with the same period last year.1
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.
Source
1HMRC tax receipts and National Insurance contributions for the UK (monthly bulletin) - GOV.UK
In The Picture
In the US, technical moves such as selling underperforming shares for tax reasons and reinvesting the proceeds, also contribute to this upbeat end to the year.
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