The S&P 500's Next Shock May Come From Another Country — And It's Not Iran

While the market awaits the next catalyst from the Middle East, institutional money eagerly awaits the next signal from Tokyo.

The Bank of Japan (BOJ) is meeting today and tomorrow to discuss the next policy move. While the consensus is to hold rates unchanged, the jitters are about what happens next.

Untangling the Carry Trade

For decades, Japan has been the anchor of ultra-loose monetary policy. Now, even a modest tightening threatens to unwind one of the largest and least appreciated sources of leverage underpinning global markets — the yen carry trade.

"The BOJ will stand pat this time but deliver a hawkish message with an eye on a rate hike in June or July," Tetsuya Inoue, executive economist at Sony Financial Group, said according to Reuters.

"Corporate price-setting behavior has changed, so the BOJ must keep an eye out for signs of second-round effects," he added.

Meanwhile, ING Think's research still sees a risk of a hike tomorrow, "if the BoJ gives priority to preventing inflation expectations from accelerating." In a note from April 24, the bank suggested that "energy shocks are having a more prolonged and much larger impact on inflation than on growth."

The shift in Japan's inflation risk has a profound effect. Since the 1990s, the global financial system has benefited from cheap yen funding. Borrowing in cheap, low-yielding yen, investors piled into U.S. equities, emerging markets, and credit. As long as Japanese rates stayed low and the yen remained weak, the trade was self-reinforcing.

But that dynamic is no longer the case. A rate hike, or even credible signaling of one, tends to strengthen the yen. That alone can force investors to unwind positions as borrowing costs rise and currency losses mount – rapid deleveraging.

The August 2024 episode was one such episode. A sudden shift in BOJ policy triggered a sharp, synchronized sell-off in equities and bonds, and the S&P 500 fell by over 8% off its July peak. Though leverage has come off slightly since the beginning of 2026, FINRA's data still shows it grew by about 40% year over year.

The Spillover Risk

However, every ledger has two sides, and Japan's role in foreign asset ownership is significant. The country is the largest foreign holder of U.S. Treasuries, as its institutional investors have long recycled domestic savings into U.S. debt, attracted by higher yields.

But if yields rise at home, or if currency risks increase, those flows could reverse. Even a partial repatriation of capital would put upward pressure on U.S. yields, tightening financial conditions just as markets remain priced for resilience.

The Bank of Japan's latest Financial System Report elaborated on how interconnected these dynamics have become. The institution warned about the influence of foreign hedge funds, which now account for around 60% of trading volume in its bond market and nearly 80% in futures.

Such investors engage in various leveraged arbitrage strategies; therefore, stress elsewhere can quickly spill over into Japan – and vice versa.  The BOJ cautioned that, if global funds are forced to deleverage, the shock could transmit through the Japanese bond market and trigger a broad global liquidity squeeze.

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