$23 billion massive retreat! The Japanese are handing over the bull market to foreigners

The Japanese financial market is experiencing a long-awaited wave of re-inflation trading, but domestic investors are unexpectedly absent from this feast.

According to statistical data, foreign capital inflows have reached the strongest level in the past decade this year, expected to set a record high since the influx of funds triggered by Abenomics in 2013. Foreign investors have dominated this round of gains that pushed the Tokyo stock market to a historic high, while also selling off Japanese government bonds in large quantities, driving the 30-year government bond yield to reach a historical peak.

According to Nicholas Smith, a strategist at Lyon Securities in Tokyo, "Global investors have been the main driving force behind the rise of the Japanese stock market," and during the process of the Tokyo Stock Exchange index rebounding 34.2% from its April low, "there are almost no signs showing that domestic investors are chasing the rally."

Meanwhile, Japanese retail investors have withdrawn about $23 billion this year, reflecting a cautious attitude towards market prospects. Analysts believe that if Japanese retail investors re-enter the market, there may be further upside potential for the stock market.

Factors such as the Bank of Japan's policy shift have triggered an asset rotation effect, but the lack of capital inflow has become a key constraint. Despite significant fluctuations in the stock and bond markets, the yen exchange rate has remained relatively stable, fluctuating within the 140-160 range for the past two years, failing to benefit from stronger growth prospects or inflows of investor capital.

Market Structure Change Driven by Foreign Capital

Foreign investors are reshaping the structure of Japan's capital market.

Against the backdrop of government support policies and corporate reforms reigniting economic growth in Japan after nearly thirty years of stagnation, the Bank of Japan raised interest rates for the first time this year and reduced its massive government bond holdings, marking the first rate hike since the global financial crisis in 2008.

This policy shift has triggered an asset rotation from bonds to stocks, boosting battered industrial stocks while sacrificing more attractive growth stocks, and favoring short-term bonds over long-term bonds.

The trend of value stocks outperforming growth stocks reflects the typical characteristics of re-inflation trading, which quantitative investors often interpret as a signal of more dispersed economic growth across the economy.

Smith from Lyon Securities pointed out, "Foreigners are not the only buyers: the amount purchased by companies through stock buybacks is even larger. This is very exciting because companies are cash-rich and have the capacity to buy more stocks."

Domestic Investors' Cautious Sentiment

The absence of Japanese retail investors has become a significant feature of this rally. Bernstein analysts attribute the cautious attitude of retail investors to uncertainty about how U.S. tariffs will affect the Japanese economy and market volatility.

However, the situation may be changing. Bernstein analysts stated, "Retail investor sentiment has finally turned positive again since last week after reaching extremely pessimistic levels." They believe that the combination of profit recovery, strong confidence from foreign investors, and the return of retail funds "looks quite favorable for the market."

Analysts believe that if Japanese retail investors re-enter the market, the stock market's upward momentum may continue further. The current re-inflation trade still largely relies on foreign capital, and the level of participation from domestic investors will determine the sustainability of this market trend.

The Funding Dilemma Behind the Stability of the Yen Exchange Rate

Despite significant fluctuations in the stock and bond markets, the yen has remained relatively stable, a phenomenon that has drawn market attention. Brad Setser from the Council on Foreign Relations pointed out that "the biggest issue is the lack of capital inflow."

He attributes this to Japanese institutions having invested heavily in the U.S. Treasury market before the pandemic, and these investments are now effectively at a loss following the Federal Reserve's interest rate hikes. In short, Japanese capital has chosen to stay overseas rather than return home to chase yields.

This situation creates unique arbitrage opportunities. Foreign buyers can obtain considerable yield differentials from Japanese government bonds compared to U.S. Treasuries of the same maturity. The yield on five-year U.S. Treasuries is only 3.86%, while the yield on five-year Japanese government bonds, when converted to dollars, reaches 5%. Such arbitrage opportunities in the bond market can only be realized when there is a significant interest rate differential between the Federal Reserve and the Bank of Japan.

However, this advantage exists only in one direction. Due to the relatively low interest rates set by the Bank of Japan, Japanese investors find that investing in the U.S. market on a currency-hedged basis is more costly, which further explains why domestic funds have not returned on a large scale.

The market is closely watching whether the rotation of Japanese assets will continue to deepen. Although Japan has lost its status as the world's largest creditor nation this year, it still holds a significant amount of financial assets overseas, which theoretically could be sold and repatriated