Japan’s Negative Rates : The Hidden Threat to US Tech Stock Valuations

Japan's Negative Rates: The Hidden Threat to US Tech Stock Valuations 

As the US stock market continues to reach new highs, it's natural for investors to speculate about where the greatest risk to this bull market might come from. However, many are focused on the wrong potential threats. The biggest risk to the bull market isn't from a US recession, persistent inflation, weak stimulus from China, or even a stagnant European economy. Surprisingly, the real danger comes from Japan.

Japan's deeply negative real interest rate is an economic imbalance that is both unprecedented and unsustainable. When markets face major risks, it often occurs when two factors converge: an extreme financial condition and investors failing to recognize it. Right now, Japan's economic situation fits both of these criteria, but it seems that most are turning a blind eye to it.

Japan's real policy interest rate currently stands at -2.3%, an extreme level. The gap between Japan's real rate and that of the US is even more staggering, sitting at -5.4%. Since 2022, the differential between these two economies has shifted by an incredible 12 percentage points, which is an unprecedented change in such a short time frame. What's most concerning is that very few seem to have noticed that Japan's deeply negative real rates have fueled a surge in US tech stock valuations, contributing to a significant inflation in this sector.

The evidence is clear. Between 2017 and 2022, US tech stock valuations moved in tandem with long-duration bond prices, as economic theory would predict. At the same time, tech stock valuations were positively correlated with the Japanese yen. This relationship persisted until the first half of 2022 when a sharp correction in tech valuations coincided with a weakening yen. Yet in the latter half of 2022, tech stocks decoupled from long-duration bond prices and developed an almost perfect negative correlation with the yen. This reversal occurred precisely when Japan's real interest rates turned deeply negative, both in absolute terms and relative to US rates.

The post-2022 correlation between tech stock valuations and Japan's negative real rates suggests that borrowing in yen at ultra-low rates has fueled the latest surge in US tech stock inflation. The situation was exacerbated by the release of ChatGPT-4 in March 2023, which further inflated tech valuations, driven by the hype surrounding AI. Despite Nvidia's booming sales in AI chips, no company has yet struck significant "AI gold," raising doubts about the sustainability of these surging valuations.

In late July and early August 2023, when Japan's negative real rates started to reverse, it triggered a sharp correction in tech stocks. This occurred due to expectations of rate hikes by the Bank of Japan, combined with anticipated rate cuts from the Federal Reserve. The resulting turmoil affected both Japanese and US markets.

As evidence mounts, it becomes clear that Japan's deeply negative real rates have fueled the inflation in US tech stocks. This situation is unsustainable, and when it unwinds, it could lead to a stronger yen, a decline in tech stock valuations, and significant market shifts. The real risk to the bull market lies in Japan, not the US.