Japan’s GDP grew at a 3.3% annualized rate, which is much stronger than expected. As the Financial Times is reporting today there is a high probability that the Japanese Central Bank will raise interest rates in August to cool the hot economy.

Why the panic here in the US? Well, the Japanese are the most enthusiastic buyers of US Mortgage Bonds. There has been a phenomenon lately called the “Yen carry-trade” where investors borrow money in Japan at very low interest rates and buy US Mortgage bonds paying much higher returns. In recent years these investors have made a comfortable return on their money with very little risk.

The first shock in the carry-trade came earlier this year with the continuing weakness of the dollar. A weak dollar ate directly into the spread. If the Japanese central bank raises rates in August, it will further eat into the spread and slow Japanese purchase of bonds. This weakening in demand will translate into higher interest rates.

Not everything happens so neatly, but there is a clear possibility and my hunch is rates will rise a bit more yet before peaking. Here is some more detailed analysis.

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