Japan's Re-inflation Trade: Foreign Capital Takes the Lead, Local Fund Inflows May Support Continued Uptrend

According to the Zhitong Finance APP, the Japanese financial market is experiencing a long-awaited "re-inflation trade," with the only absence being domestic Japanese investors. Under the dominance of foreign investors, the Japanese stock market reached a historic high last month, and the yen also appreciated. Foreign investors are also significant buyers of Japanese government bonds, leading to a historic peak in the yield of 30-year Japanese government bonds.

Data shows that since hitting a low in April, the Tokyo Stock Exchange index has risen by 34.2%. Nicholas Smith, a strategist at CLSA in Tokyo, stated, "Global investors are a key driving force behind the rise of the Japanese stock market." He added, "There is almost no sign of domestic Japanese investors chasing the rally."

With government supportive policies and corporate reforms helping Japan reignite economic growth after nearly three decades of stagnation, the Bank of Japan raised interest rates for the first time since the global financial crisis in 2008 and reduced its massive holdings of Japanese government bonds this year.

This move has driven a rotation of assets between bonds and stocks, significantly strengthening traditional industrial stocks while high-growth stocks have relatively faded. Meanwhile, in the Japanese government bond market, investors prefer short-term bonds over long-term bonds.

Some analysts believe that if Japanese retail investors return to the stock market after withdrawing about $23 billion this year, this upward trend may have a longer way to go. Bernstein analysts noted in a research report, "Retail sentiment has finally turned positive since last week, after being extremely pessimistic for a time."

Strategists believe that the caution among retail investors stems from uncertainty about how U.S. tariffs will affect the Japanese economy and market volatility. However, they added that the combination of profit recovery, strong confidence from foreign investors, and the return of retail funds is "very favorable for the market."

So far this year, the inflow of foreign funds into the Japanese stock market is the strongest in the past decade, expected to reach the highest level since the influx triggered by "Abenomics" in 2013. Nicholas Smith added, "It's not just foreigners buying; the scale of corporate buybacks is even larger." "This is very encouraging because companies have ample cash and are fully capable of conducting more buybacks."

Despite significant fluctuations in the stock and bond markets, the yen has remained relatively stable. Over the past two years, the USD/JPY exchange rate has "stubbornly" maintained a range of 140-160, without strengthening due to improved growth prospects or investors pouring funds into the Japanese market for higher bond yields or stock returns.

Brad Setser, a senior fellow at the Council on Foreign Relations (CFR), stated, "The key is the lack of repatriated funds." He pointed out that this lack is mainly due to Japanese institutional portfolios having invested heavily in U.S. government bonds before the pandemic, but these investments have almost "been trapped" after the Federal Reserve raised interest rates.

In short, Japanese capital remains overseas rather than returning home to chase yields. Analysts and traders are closely watching whether this trend will change as the Japanese financial market fully activates Here are some charts showcasing asset rotation in Japan:

1. Asset Class Rotation

Investors betting on stronger economic growth are pulling out of fixed income assets and shifting towards the stock market. The Nikkei 225 Index and the TOPIX Index have both reached historical highs this year.

2. Value Stocks Outperform Growth Stocks

Similar to re-inflation trades in other countries, Japanese value stocks have outperformed growth stocks. Quantitative investors typically interpret this trend as growth momentum spreading more broadly across the economy.

3. Arbitrage Trading

Foreign buyers can achieve significant excess returns in Japanese government bonds. The yield on five-year U.S. Treasuries is only 3.86%, while the same maturity Japanese government bonds can offer a yield of 5% after dollar swaps. This "magic" in the bond market is possible due to the substantial interest rate differential between the Federal Reserve and the Bank of Japan.

4. Yen Hedging Costs

The aforementioned arbitrage trades are only effective for foreign investors. Due to the relatively low interest rates set by the Bank of Japan, Japanese investors face higher costs when making currency-hedged investments in the U.S.

5. Japan's Overseas Wealth

Earlier this year, Japan lost its title as the "world's largest creditor nation," which was taken over by Germany. However, Japan still holds a considerable amount of financial assets overseas, which could be sold and brought back to the domestic market if necessary.