The world economy is at risk of having a severe financial crisis, which will be accompanied by a surge in unemployment rates and a stock and crypto market crash.

As someone who has been investing for 20 years and working in investment firms for years, I will break down what’s happening, what the Japanese carry trade is, the problems faced by the Japanese economy, and how it will affect the US and the whole world in this article.

Here’s why I think this might happen and what I’m doing to protect myself from the coming financial crisis.

Japan’s Economy is a Pressure Cooker About to Explode

Everything has a price. Even stability.

When a government or a central bank tries to control the normal economic fluctuations by manipulating rates and monetary policies, the result is always a building up of economic pressure.

Japan has been doing this for a while. They have had a housing market collapse, earthquakes, and a nuclear disaster, and to deal with that, they have kept interest rates extremely low.

The Bank of Japan has kept interest rates near zero since 1999. But as Nassim Taleb said, these measures “come at a price you eventually must pay.”

Japan’s Economic Success is a Myth

Over the years, many economic “experts” have pointed to Japan as a model where low interest rates can coexist with low inflation.

However, I don’t think the situation is as rosy as it seems. Japan’s approach has prevented inflation and maintained what appeared to be economic stability, but their monetary policies have second-order long-term effects.

Politicians and central bankers try to prevent inflation and deflation by controlling interest rates and the money supply, but under the hood, it’s all market manipulation that, sooner or later, we have to pay for.

Saying this, I think…

Japan has been living in a lie, and the world has believed in this lie until now.

Now, the truth is coming up, and everyone is about to pay the price.

Here’s what’s happening.

The Japanese Yen Carry Trade Sell-Off

One of the side effects of the artificially low Japanese interest rates was the carry trade.

Here’s what the Japan carry trade has been and why it now risks crashing the world markets:

• Investors have been borrowing JPY (Japanese Yen) at a nearly 0% interest rate.
• They use this money to invest in stocks and US treasury bonds. Since US treasury bonds pay around 5%, borrowing at nearly 0% to get a 5% yield and pocketing the difference seems a no-brainer.
• Additionally, the JPY/USD rates have been declining since 2013, making these JPY loans cheaper to pay.

The chart below shows the Japan interest rate in blue and the JPY/USD chart:

• The amount of these JPY loans is very large. According to the BIS—Bank for International Settlements—the total loans as foreign currency are over $40 trillion Yen (approx. $270 billion USD). See the chart below:

• Investors, particularly hedge funds, have been leveraging the “no-risk” Japan carry trade to maximize their profits, with some funds leveraging the trade 5x, 10x, or even 20x. This leveraging, combined with the derivatives market, has multiplied the size of the carry trade to an astonishing USD 20 trillion, making it a massive factor in the global financial landscape.
• Leveraging at these levels can multiply profits during good times or losses during bad times. The bad times are now approaching.
• These billions of dollars have been flowing into the US stock market and US bonds. However, Japan is about to pull the rug on the markets.

The unwinding of this carry trade in its entirety can result in a full market crash across all asset classes.

Imagine the S&P 500 crashing by 40%, Bitcoin crashing by 80%, and US treasury bonds crashing by 30%.

Free Money Will Haunt You

For almost two years, I’ve extensively discussed the Japanese carry trade with my friend Tony. As professional investors, we always explore the best ways to yield our investments, but the simplest investment strategies are often the best.

Why simple is best? When you make it complex, there are multiple second and third-order effects that are hard to predict.

One example is this JPY carry trade.

It seems easy on the surface: get a 0% JPY loan, buy USD stocks or bonds that pay 5% to 10%, and pocket the difference.

The problem is that it’s not that simple. There are many second-order effects. Many “ifs”:

• JPY/USD has been going down, but what if it goes up? If it does, these JPY loans will be more expensive to repay.
• The Japanese rates have been close to zero, but what if they go up — like they just did in early August 2024?
• What happens if we see further narrowing in the yield differential between Japan and the US?

If these things happen, that “free money” actually comes at a high cost.

The carry trade looks like a genius move until one moment when it stops working and generates huge losses. These huge losses are now wiping out the traders and funds that profited from the carry trade and haunting the world economy.

The Japanese consumer will also pay the price. Sorry.

I Have Serious Concerns Regarding the Japanese Economy Affecting the World

Under the hood, the Japanese economy is a total mess. Here’s why it can put the whole world at risk.

It’s a puzzle, and when you connect all the dots below, you will see why it’s a mess:

• Japan’s real GDP grew close to zero in 5 years.
• Simultaneously, the Japanese stock market grew by 67% (150% from the bottom to the top). Something is not matching here, right? The chart below shows the GDP growth in orange and the Nikkei 225 (Japan stock market) in blue:

• Japanese government debt to GDP is a staggering 263%, and it doesn’t seem to be able to slow down. See the chart below:

• Even with the currently low rates, 25% of the Japanese government budget already goes to servicing debt. If the Bank of Japan increases the rates, debt interest and repayment will be unsustainable, putting Japan at risk of bankruptcy.
• Japan’s inflation rate is accelerating. This is happening in part because the JPY/USD price has been declining, making it more expensive for Japan to buy USD-denominated commodities (oil, metal, cereals, etc.). Inflation is at one of the highest levels since 1985. See the chart below:

• The Japanese population is getting older, and the current median age is 48. See the chart below:

• 33% of Japan’s government spending goes to social security and pensions, a number that will increase due to the aging population. This is additional pressure on Japanese debt.
• Additionally, the Japanese population is shrinking due to the low birth rate, and the working population has shrunk by 20 million over the last 20 years. See the chart below:

So, in a nutshell, Japan is in a very fragile situation, and Japan illustrates well how having governments with large debts impacts their ability to maneuver themselves during difficult times.

Debt payments (especially huge debt like the Japanese) come due by either:

• Economic recession. Japan is closer than ever to bankruptcy.
• Massive taxes (which can lead to recession, too).
• Inflation and money printing (which deepens the problems).

There’s no other way for Japan to escape from its tricky economic situation. It’s an escape room with no way out.

You see where this is going. It would require a miracle for the Japanese economy not to implode and for the rest of the world not to be dragged with it.

But sadly, sooner or later, the economy is going to break.

“If it keeps on raining, the levee’s going to break

When the levee breaks, have no place to stay

Crying won’t help you, praying won’t do you no good”

— Led Zepellin

The Contagion to the US and World Economy

The weight of the Japanese economy in the US is very large, which makes any Japanese economic problem an American problem. And…

American problems are world problems.

Let me say this again: Japan’s economic situation is unique, and no one can predict what’s going to happen. There are too many unknowns from this economic experiment, and no one can rule out that a massive blowup can be one of the outcomes.

Here’s how Japan affects the US and the whole world:

• Japan is the number one foreign direct investor in the US economy, in part due to the carry trade. A Japanese implosion can implode the US stock market. See the chart below:

• The US is very dependent on Japan to continue buying their debt, which is now growing by $1 trillion every 100 days.

• Japanese companies are the biggest foreign employers in the US, employing close to 550,000 Americans. A Japanese implosion can lead to an increasing unemployment rate in the US, as shown in the chart below:

• Japanese companies in the US are the ones responsible for the biggest portion of US exports, after American companies. These exports amount to over $100 billion annually.

I think you get the point.

Another Housing Market Collapse?

A blow-up of the Japanese economy or a significant increase in Japanese interest rates will affect the United States severely and, consequently, the global economy.

One of the second-order effects of a Japanese economic crisis could be a housing market collapse in the U.S., potentially on the scale of the 2007 financial crisis.

Here’s why:

• Due to the unwinding of the Japanese carry trade and the collapse of the Japanese economy, investors will sell massive amounts of US treasury bonds.
• This sudden increase in the supply of US bonds in the market puts downward pressure on bond prices.
• Bond prices and yields have an inverse relationship. When bond prices fall, their yields rise.
• Bond yields are 93% correlated to mortgage loan yields, meaning that mortgage loans can suddenly become very expensive and unaffordable for families.

The chart below illustrates this well: In purple, we have the treasury bill prices; in orange, the treasury bill yield; and in red, the mortgage loan rates. They are highly correlated.

In other words, the Japanese selloff can trigger higher US mortgage rates, putting US households under huge stress, which can lead to something similar to the 2007 financial collapse.

People won’t have money to pay their loans; consumption will decline, the economy will decline, the housing market will implode, and everything will crash.