Investing.com -- The biggest threat to the S&P 500 bull market is not a US recession, but Japan’s deeply negative real rates relative to the US, according to BCA Research strategists.
In a Wednesday report, the investment research firm highlighted that Japan’s real policy interest rate differential versus the US has reached an unprecedented and unsustainable level of -5.4%.
“Since 2022, Japan’s real policy interest rate differential versus the US has changed by a remarkable -12 percentage points,” BCA Research strategists noted.
BCA stresses that Japan’s negative real rates have significantly contributed to the rampant inflation in US tech stock valuations, particularly in the AI sector.
Tech valuations, which previously tracked US bond prices, decoupled in 2022 and instead began to move in near-perfect inverse correlation with the Japanese yen. This shift occurred just as Japanese real rates plummeted, both in absolute terms and relative to the US.
“The post-2022 perfect correlation of tech stock valuations with Japan’s deeply negative real rates – and hence with the inverted yen – provides strong evidence that borrowing in yen at deeply negative real rates has fuelled the latest inflation in US tech valuations,” the firm explained.
The rally in tech valuations received a major boost following the launch of ChatGPT-4 in March 2023, however, BCA argues that the surge was not solely a product of that launch.
While AI hype provided a narrative for the massive flows into US tech, the underlying cause has been yen-funded borrowing at deeply negative real rates, BCA notes.
“After all, the sales and profits of AI chip designer Nvidia (NASDAQ:NVDA) are booming. Yet Nvidia is simply providing the ‘picks and shovels’ in the AI gold rush,” the report continues.
“Even with these expensive picks and shovels, no company’s sales or profits has yet reported finding any AI gold. And it is unclear when, or whether, any company will find any AI gold.”
A warning sign emerged in July 2024 when tech stocks suffered a sharp correction. This was triggered by rising speculation that the Bank of Japan (BoJ) would end its zero-interest rate policy (ZIRP), followed by a “hawkish” rate hike on July 31, 2024.
At the same time, expectations for aggressive US Federal Reserve rate cuts, following a weak US jobs report, contributed to a sharp reversal in Japan's real rate differential versus the US.
This caused “carnage” in US tech stocks, further underscoring the risk of a similar event happening again if Japan’s deeply negative real rates begin to unwind.
BCA points out that a long position in the Japanese yen would serve as a solid hedge against US tech stock weakness, given the near-perfect negative correlation between the yen and tech valuations.
“If deeply negative yen rates versus the US are unsustainable then so is yen weakness,” BCA said, pointing to strong upside potential in the Japanese currency.
Higher real rates in Japan compared to the US, along with a stronger yen, would likely lead to a deflation in US tech stock valuations, similar to what occurred in July and August 2024.
Alternatively, a collapse of the hype and optimism surrounding generative AI could trigger an unwinding of yen-funded leveraged positions in US tech, which would also result in a stronger yen.