Investors have been rattled by a rising U.S. bond yield. They should be more worried about Japan.

Japan’s flag flutters near the Bank of Japan’s building in Tokyo. A recent selloff in the country’s long-dated government debt is raising worries about the potential impact on U.S. assets. - AFP/Getty Images

A previous version of this story inaccurately described the closing direction of the stock market.

A soaring 30-year Treasury yield has grabbed the lion’s share of attention lately when it comes to signaling how the U.S. fiscal outlook is rattling investors. Yet there’s another less-talked-about factor weighing on sentiment and coming from overseas.

It is the recent tumultuous rise in Japan’s bond yields. A weak 20-year bond auction in Japan a few days ago sent the country’s 30-year yield BX:TMBMKJP-30Y to almost 3.17% on Thursday, the highest in roughly 25 years of record-keeping. Its 40-year yield BX:TMBMKJP-40Y also jumped to 3.67%, the highest level since its inception in 2007.

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Japan’s financial institutions are known to be big buyers of U.S. Treasurys, and have helped to bolster the global bond market in the past through what’s known as the yen-funded carry trade. This trade involves borrowing in yen to buy a higher-yielding currency like the dollar, which is then invested in bonds of that currency. But that era appears to be ending, putting both Treasurys and U.S. stocks at risk, according to one strategist.

If sharply higher yields on Japanese government bonds entice the country’s investors to return home, “the unwinding of the carry trade could cause a loud sucking sound in U.S. financial assets,” said strategist Albert Edwards of the French-based bank Société Générale.

“Most commentators attribute the rise in U.S. 30y yield to 5% to U.S. domestic fiscal developments without putting it into a wider global context. Both the U.S. Treasury and equity markets are vulnerable, having been inflated by Japanese flows of funds (as has the dollar),” Edwards wrote in a note on Thursday.

The strategist added: “I would rank trying to understand and follow the surging long end of the JGB market as the No. 1 most important thing for investors at the moment.”

Edwards’ comments suggest the recent selloff in the Japanese bond market may have played at least some role in the Treasury market’s own selloff of the longest-dated government maturity Thursday morning. 

The 30-year Treasury yield, which rises when the price on the underlying bond falls, jumped to an intraday high of 5.15% and was on pace at one point for its highest closing level since 2007. Then during the New York afternoon, the bond rallied, sending the 30-year yield down by 2.6 basis points to 5.063%.

Meanwhile, the Dow Jones Industrial Average DJIA and S&P 500 SPX ended marginally lower, while the Nasdaq Composite COMP saw a 0.3% gain.

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Thursday’s U.S. bond-market action had largely been attributed to the early-morning decision of House Republicans to advance a huge tax and spending bill from President Donald Trump. That bill was raising worries about the U.S. fiscal outlook and willingness of investors to keep buying U.S. debt.

Read: Surge in Treasury yields points to U.S. debt concerns as Trump’s tax bill advances. Investors want this fix.

Researcher George Saravelos of Frankfurt-based Deutsche Bank said the single most important indicator of accelerating U.S. fiscal risks is the gap between Treasury yields and the Japanese yen. The yen has strengthened even as Treasury yields rise, which he sees as “evidence that foreign participation in the U.S. Treasury market is declining.” 

Some have interpreted spiking yields in Japan as a sign of rising fiscal worries about the Asian country, he said on Wednesday. “We would argue the JGB sell-off is a bigger problem for the U.S. Treasury market: by making Japanese assets an attractive alternative for local investors, it encourages further divestment from the U.S.”

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