It’s not AI, and it’s not war—should the US stock market be most worried about Japan?

Global markets are underestimating a potential systemic risk—Japan. As the yen falls to multi-decade lows and Japanese domestic assets become more attractive, the world’s largest pension fund faces policy pressure to shift its assets back home at scale. Once this process begins, US equities, the bond market, and the dollar could face simultaneous headwinds.

Recently, Japanese Prime Minister Hayato Takatsuki said the government will push the Japan Government Pension Investment Fund (GPIF) and other national pension funds to increase investments in Japan’s domestic financial assets. The Minister of Finance, Akiyuki Katayama, had previously sent similar signals. Although GPIF has not yet announced any formal changes to its asset allocation, markets have already started to assess the potential impact: if the fund moves its overseas holdings back to Japan, US Treasury yields could rise, the dollar could weaken, and risk assets could come under pressure.

At present, market pricing for the above risks remains relatively calm, but some technical indicators have shown subtle changes, and investors should not take this lightly.

A variable of $1.8 trillion

GPIF manages about $1.8 trillion, with domestic and overseas assets each accounting for roughly half. Overseas holdings total about $930 billion. In recent years, the size of Japanese government bond holdings held by the fund has fallen from about $770 billion to $515 billion, while foreign bond holdings have risen from $128 billion to $18k.

This structural change implies that even modest asset reallocation could trigger significant volatility in global markets. According to MarketWatch, analyst Michael Kramer noted that if GPIF brings some overseas assets back to Japan, it would directly boost demand for yen and introduce large-scale buying into the Japanese government bond market—good for Japan, but for the US it would mean higher interest rates and a weaker dollar.

Meanwhile, if Japanese yen carry trades (borrowing low-interest yen, converting to dollars, then investing in US assets) see large-scale liquidations, they would further suppress the performance of risk assets.

Yen vs. Japanese bonds: Domestic asset attractiveness is rebounding

Behind the potential reshuffling of GPIF assets is a substantial improvement in Japan’s domestic asset fundamentals. As inflation rebounds and economic growth recovers, domestic investment opportunities have become notably more attractive. In February this year, the yield spread between US and Japanese two-year government bonds narrowed to the lowest level since early 2022.

At the same time, the yen has continued to weaken. The USD/JPY rate broke above 163, reaching the highest level since 1986. From a technical analysis perspective, if the exchange rate moves higher further, the next resistance level is around 176. As reported by the UK’s Financial Times, Neuberger Berman’s Fredrik Repton believes that if GPIF allocates more funds to domestic assets, it could be a “very elegant solution” for Japan’s macro issues, but other domestic financial institutions would also need to follow, and “this process will take a long time.”

Japanese 10-year government bond yields have recently touched 2.7%, the first time in 30 years. In a recent report, Deutsche Bank analyst Mallika Sachdeva said Japan’s policy focus may be shifting from exchange-rate management to yield management. If that proves true, it would put additional pressure on the yen.

Not priced yet, but signals are emerging

So far, global markets have been relatively restrained in reacting to the risk of Japanese capital returning. The five-year USD/JPY cross-currency basis swap recently hovered around negative 30 basis points, the narrowest level since the series started in 2021. This indicates that the market’s demand to hedge yen appreciation has not clearly increased.

However, this indicator itself is a key signal for whether flows of funds are starting to change direction. Historical data show that the S&P 500 index and the cross-currency basis swap have moved in sync in multiple periods: whenever hedging demand rises sharply, US equities often fall, because liquidity tightens. Once market expectations for yen appreciation heat up, demand for dollar hedging would climb, making the liquidity-tightening effect more pronounced.

Japan’s stock market: Another side beyond risk

Importantly, while potential GPIF asset reallocation would add pressure to the US market, it also provides Japan’s stock market with a new narrative. Japan’s stock market is benefiting from forces that are very different from those in the US: the concentration of the technology sector in the TOPIX is far lower than in the S&P 500, its exposure to artificial intelligence is relatively limited, and valuations still trade at more than a 20% discount versus the S&P 500.

Corporate governance reform is a core catalyst for Japan’s stock market. Verdad Advisers’ Dan Rasmussen said Japan still has about 1,000 companies whose stock prices are below their book values, and among the cheapest fifth of companies, cross-shareholdings account for about 40% of their market capitalization. As cross-shareholdings are gradually unwound, a large amount of accumulated profits from the past could be released, creating a meaningful positive impact on corporate earnings.

However, for overseas investors, a persistently weaker yen is the biggest obstacle. Over the past two years, yen depreciation has significantly eroded the real returns of foreign capital in Japan’s stock market. How to handle FX hedging—and whether the hedging cost is affordable—remains the central question facing global investors.