Will Japan's interest rate hike trigger a global liquidity shock?

Author: Long Yue, Wall Street Insights

As the Bank of Japan’s monetary policy meeting approaches on December 19, market concerns about the possibility of hawkish rate hikes are intensifying. Will this move end the era of cheap yen and trigger a global liquidity crisis? Western Securities released its latest strategic report on December 16, providing an in-depth analysis.

High Inflation, Japan’s Hawkish Rate Hike Is Inevitable

The report points out that there are multiple driving factors behind the BOJ’s rate hike this time. First, Japan’s CPI has remained above the official inflation target of 2%. Second, the unemployment rate has been maintained below 3% for a long time, creating favorable conditions for nominal wage growth, and market expectations for wage increases in next year’s “Shunto” (spring labor negotiations) are high, which will further pressure inflation. Lastly, Sanae Takaichi’s announced fiscal policy of 21.3 trillion yen may also exacerbate inflation.

These factors collectively compel the BOJ to adopt a more hawkish stance. Market concerns are that once the rate hike is implemented, it will lead to a large-scale unwinding of “carry trade” positions accumulated during the YCC (Yield Curve Control) era in Japan, potentially causing liquidity shocks in global financial markets.

Theoretical Breakdown: Why the Most Dangerous Phase of Liquidity Shock May Have Passed?

Despite market anxiety, the report analyzes that, in theory, the current Japanese rate hike has limited impact on global liquidity.

The report lists four reasons:

1. Risks Have Partially Eased: The BOJ has already raised rates three times since March last year. Among these, the July rate hike combined with the exit from YCC did cause significant liquidity shocks, but the impact of the January rate hike has weakened markedly, indicating increased market adaptability.
2. Speculative Positions Have Exited Early: According to futures market data, most speculative yen short positions were closed by July last year. This means the most active and potentially chain-reacting “carry trade” positions have already receded, and the most dangerous phase of liquidity shock has passed.
3. Different Macro Environment: Currently, the US is not experiencing a “recession trade” similar to July last year, and the dollar’s depreciation pressure is limited, while the yen itself is weak due to geopolitical and debt issues. This reduces the yen’s appreciation expectations, alleviating the urgency of unwinding carry trades.
4. The Fed’s “Safety Buffer”: The report specifically mentions that the Federal Reserve has begun to pay attention to potential liquidity risks and has started expanding its balance sheet (similar to QE), which can effectively stabilize market liquidity expectations and provide a buffer for the global financial system.

Actual Risks: “Catalyst” in Fragile Markets

The report emphasizes that theoretical safety does not mean being worry-free. The current fragility of global markets is the real root of potential shocks triggered by Japan’s rate hike. The report describes this as a “catalyst.”

The analysis states that the significant impact of Japan’s July rate hike was due to the resonance of two major factors: “large-scale unwinding of active carry trades” and the “US recession trade.” Currently, the first condition has weakened. However, new risks are emerging: the global stock markets, represented by US equities, have experienced a “big water buffalo” for six years, accumulating a large amount of profit-taking positions and becoming fragile. Meanwhile, concerns about an “AI bubble” in the US have resurfaced, with risk-averse sentiment prevailing.

However, the global stock markets, represented by US stocks, have been a “big water buffalo” for 6 years, which makes them inherently fragile, and concerns about the “AI bubble” in the US have re-emerged, with risk-averse sentiment strong. Yen rate hikes could potentially become a “catalyst” that triggers a global liquidity shock.

In this context, Japan’s rate hike, as a certain event, is very likely to become a fuse, triggering panic withdrawals of funds and causing a global liquidity shock. However, the report also offers a relatively optimistic view: such a liquidity shock will most likely force the Fed to implement even more aggressive easing policies (QE), so after a brief sharp decline, global stock markets are likely to recover quickly.

More Observation, Less Action; Watch for “Three Kill” Signals in Stocks, Bonds, and Forex

In the face of this complex situation, the report advises investors to “observe more and act less.”

The report believes that since the BOJ’s decisions are basically “clear signals,” but the flow of funds is unpredictable, the best strategy is to stay cautious.

• Scenario 1: If there is no panic withdrawal of funds, the actual impact of Japan’s rate hike will be very limited, and investors need not take action.
• Scenario 2: If panic truly triggers a global liquidity shock, investors should closely monitor a key signal — whether the US market experiences 2-3 consecutive “three kills” in stocks, bonds, and forex (i.e., simultaneous declines in stock, bond, and currency markets). The report notes that if a repeat of the situation in early April this year occurs, it indicates a significantly increased probability of liquidity shocks.

Finally, the report believes that even if Japan’s rate hike causes short-term turbulence, it will not change the overall medium- to long-term trend of monetary easing globally. Against this backdrop, it remains optimistic about gold’s strategic allocation value. Meanwhile, with China’s export surplus expanding and the Fed restarting rate cuts, the RMB exchange rate is expected to return to a medium- to long-term appreciation trend, accelerating cross-border capital inflows, which is positive for Chinese assets. The report is optimistic about the “Davis double play” of profit and valuation for A-shares and H-shares. Regarding US stocks and US bonds, the report maintains a cautious view.