The significant real interest rate differential between Japan and the United States is one of the culprits for the continuous expansion of the valuation bubble in US technology stocks. With the Bank of Japan ending its negative interest rate policy and the Federal Reserve starting a rate-cutting cycle, technology stocks, as the cornerstone of the US stock market, are facing downside risks
The soaring US stock market has excited investors while also keeping a close eye on potential risks. However, Dhaval Joshi, Chief Strategist at BCA Research, believes that most people often overlook the real risks.
So, where does the biggest risk of a bull market lie? Joshi's latest report points out that the biggest risk is not a US economic recession, nor persistently high US inflation rates, nor the stagnation of the European economy—the biggest risk of the bull market comes from Japan.
He believes that Japan's deep negative interest rates have reached unprecedented levels, and the huge real interest rate differential between Japan and the US is helping to fuel the continuous expansion of the valuation bubble of US technology stocks.
Japan's extremely low real interest rates fuel the tech stock bubble
Joshi stated that Japan's current real policy interest rate is -2.3%.
The real policy interest rate differential between Japan and the US is as high as -5.4%. Since 2022, Japan's real policy interest rate differential relative to the US has decreased by 12 percentage points.
Joshi believes that such a significant change in the real policy interest rate differential between the two major economies in a short period of time is unprecedented.
What is most worrying is that almost no one has noticed that the huge real interest rate differential between Japan and the US is helping to fuel the continuous expansion of the valuation bubble of US technology stocks.
Joshi pointed out that from 2017 to early 2022, the valuation of US technology stocks was highly consistent with long-term bond prices, which is in line with traditional economic theory.
"During this period, the valuation of technology stocks was positively correlated with the Japanese yen. When the valuation of technology stocks rose in 2017 and 2019-2021, the Japanese yen also rose. And when the valuation of technology stocks sharply declined in the first half of 2022, the Japanese yen was sold off."
However, starting from the second half of 2022, this correlation was broken, and the valuation of technology stocks decoupled from long-term US bond prices, while showing a strong negative correlation with the Japanese yen exchange rate.
Of particular note is that this trend change coincided with a significant decrease in Japan's real interest rates. Whether in absolute terms or relative to the US, Japan has entered a deep negative interest rate territory.
Joshi wrote:
"After 2022, the valuation of technology stocks is perfectly correlated with Japan's deep negative real interest rates (and thus with the inverted Japanese yen), which powerfully demonstrates that arbitrage trades borrowing yen at low interest rates have fueled the rapid rise in the valuation of US technology stocks."
Japanese Negative Interest Rates Ebbing, Tech Stock Risks and Yen Opportunities Coexist
Joshi pointed out that even though the potential of AI is huge at present, no company has achieved true commercial success through AI technology, that is, found the "AI gold mine."
In July and August this year, with the adjustment of Japan's negative interest rate policy, the valuation of tech stocks showed a significant pullback. This further confirms that Japan's negative interest rates are one of the important factors driving the tech stock valuation bubble.
Joshi believes that there are two main reasons for Japan's actual negative interest rates rebound compared to the United States.
First, the shift in the Bank of Japan's policy. The Bank of Japan raised interest rates on July 31, departing from its long-standing zero interest rate policy. This led to the appreciation of the yen, thereby narrowing the interest rate differential between Japan and the United States.
Second, the change in the Federal Reserve's policy expectations. The enhanced expectations of a rate cut by the Federal Reserve led to a decline in U.S. Treasury yields, further narrowing the interest rate differential between Japan and the United States.
It is worth noting that the strong U.S. employment report released on October 4 dispelled market expectations of a significant rate cut by the Federal Reserve, leading to an increase in U.S. Treasury yields. However, due to Japan's lower interest rate level, the interest rate differential between Japan and the United States remains negative, continuing to support the valuation of U.S. tech stocks.
Joshi's conclusion is that Japan's deep negative interest rates are unsustainable, and the yen may appreciate significantly, having far-reaching implications for global asset allocation. Specifically, there are three points:
First, due to the unsustainability of Japan's deep negative interest rates, there is significant room for the yen to appreciate against the U.S. dollar.
Second, considering the negative correlation between the yen and the valuation of U.S. tech stocks, going long on the yen can effectively hedge against the risk of a decline in U.S. tech stocks.
Finally, by increasing holdings of relatively weaker-performing U.S. small-cap stocks while reducing overvalued U.S. tech stocks, a more balanced investment portfolio can be achieved