It's not AI, nor war—should the US stock market be most concerned about Japan?

The global market is underestimating a potential systemic risk—Japan. As the yen plunges to multi-decade lows and domestic asset attractiveness rises, the world’s largest pension fund faces policy pressure to repatriate assets on a large scale. Once this process begins, the US stock market, bond market, and the US dollar may come under simultaneous pressure.

Recently, Japanese Prime Minister Sanae Takaichi stated that the government will encourage the Government Pension Investment Fund (GPIF) and other national pension funds to increase investment in domestic financial assets. Finance Minister Katsuyuki Katayama had previously sent similar signals. Although GPIF has not formally announced any asset allocation changes, the market has begun assessing its potential impact: if the fund reallocates offshore positions back to domestic markets, US Treasury yields may rise, the dollar could weaken, and risk assets may come under pressure.

Currently, the pricing of this risk remains relatively calm, but some technical indicators are showing subtle changes, and investors should not be complacent.

$1.8 Trillion Variable

GPIF manages around $1.8 trillion with roughly half invested domestically and half overseas, including about $930 billion in foreign holdings. In recent years, the fund’s Japanese government bond holdings have dropped from around $770 billion to $515 billion, while foreign bond holdings have risen from about $128 billion to $470 billion.

This structural shift means that even a small-scale asset reallocation could trigger significant volatility in global markets. According to MarketWatch, analyst Michael Kramer noted that if GPIF repatriates some foreign assets, this would directly boost demand for the yen and bring substantial buying into the Japanese government bond market—a positive for Japan but implying higher interest rates and a weaker dollar for the US.

At the same time, the unwinding of yen carry trades (borrowing low-interest yen, converting them to dollars, and investing in US assets) could further weigh on risk asset performance if large-scale positions are closed.

Yen and JGBs: The Rebound in Domestic Asset Appeal

The driving force behind the potential GPIF reallocation is the substantive improvement in Japanese domestic asset fundamentals. As inflation and economic growth pick up in Japan, the attractiveness of domestic investment opportunities has increased significantly. In February this year, the US-Japan two-year government bond yield spread narrowed to the lowest level since early 2022.

Meanwhile, the yen continued its depreciation, with USD/JPY breaking above 163, the highest since 1986. From a technical perspective, if the exchange rate strengthens further, the next resistance is near 176. According to the Financial Times, Neuberger Berman’s Fredrik Repton believes that if GPIF allocates more funds to domestic assets, this could be a "very elegant solution" for Japan’s macro issues, but other domestic financial institutions would also need to follow suit and “the process will take a long time.”

The yield on 10-year Japanese government bonds recently reached 2.7%, the highest in 30 years. In a recent report, Deutsche Bank analyst Mallika Sachdeva pointed out that Japanese authorities may be shifting their policy focus from exchange rate management to yield curve management. If this transition materializes, the yen could come under further pressure.

The Market Has Not Priced It In, but Signals Are Emerging

At present, the global market’s reaction to Japanese capital repatriation risk remains restrained. The five-year USD/JPY cross-currency basis swap is currently around minus 30 basis points, the narrowest since the series was introduced in 2021, showing that demand for yen appreciation hedges has yet to rise significantly.

However, this very indicator is a key signal for monitoring whether capital flows are beginning to shift. Historical data shows that the S&P 500 Index and cross-currency basis swaps have moved in tandem at various times—whenever hedging demand surges, US equities tend to fall as liquidity tightens. Once expectations for yen appreciation heat up, demand for dollar hedges will climb, making the liquidity squeeze even more pronounced.

Japanese Equities: The Other Side of the Risk

It is noteworthy that the potential asset reallocation by GPIF, while pressuring US markets, also provides a new narrative for Japanese equities. Japan’s stock market is benefiting from dynamics distinctly different from the US: the Topix index has a much lower concentration in technology than the S&P 500, a relatively limited AI exposure, and still trades at over a 20% discount to the S&P 500 on valuations.

Corporate governance reform is a key catalyst for Japanese equities. Dan Rasmussen of Verdad Advisers points out that Japan still has around 1,000 companies trading below book value. Among the cheapest quintile, cross-shareholdings account for about 40% of their market capitalization. As these cross-shareholdings unwind, a large amount of historical profits could be released, providing a substantial positive boost to corporate earnings.

However, for overseas investors, the persistent weakness of the yen is the biggest obstacle—the yen’s depreciation over the past two years has significantly eroded the actual returns of foreign capital in the Japanese equity market. How to handle FX hedging, and whether the costs are sustainable, remain core questions for global investors.