Japan is pressing ahead with a balance-sheet reduction strategy that closely mirrors the monetary tightening playbook once championed by former Federal Reserve governor Kevin Warsh. The move, which comes as the Bank of Japan slowly unwinds years of massive bond purchases, risks tightening global liquidity and could upend the carry trades that have fueled demand for risk assets from stocks to cryptocurrencies.
Why the strategy matters now
The Bank of Japan’s shift marks a sharp departure from nearly a decade of aggressive easing. Under its yield curve control program, the BOJ became the world’s largest holder of government bonds, owning more than half of all outstanding Japanese government debt. Now, as it lets those bonds roll off its balance sheet without full reinvestment, the central bank is effectively pulling yen from the global financial system.
That process echoes the approach Warsh outlined in speeches and policy papers during his tenure at the Fed, where he argued that central banks should shrink their balance sheets quickly and predictably to avoid distorting markets. The BOJ’s current plan, while gradual, follows that same logic: reduce the stock of reserves and let market forces set long-term rates.
Impact on carry trades and risk assets
The tightening could have an outsized effect on carry trades, the popular strategy of borrowing cheap yen to invest in higher-yielding currencies and assets. With less liquidity sloshing around, the cost of those trades rises, and the yen itself may strengthen, squeezing profits for hedge funds and retail investors alike.
Risk assets — from emerging-market stocks to tech shares to Bitcoin — have benefited from the flood of cheap yen over the past decade. A sustained reduction in BOJ liquidity could reverse that flow, pressuring prices and increasing volatility. The effect is already visible in currency markets, where the yen has shown signs of firming against the dollar in recent weeks.
Market volatility ahead?
Investors are bracing for more turbulence. The BOJ’s balance-sheet reduction is happening at a time when other major central banks, including the Fed and the European Central Bank, are also shrinking their own holdings. The combined effect could drain liquidity faster than markets expect, triggering sharp moves in bonds, currencies, and stocks.
Japan’s own government bond market has already seen episodes of unusual volatility, with yields spiking as the BOJ reduces its purchases. If the central bank sticks to its plan, those swings could spread globally. The risk is that a sudden liquidity crunch forces a disorderly unwind of carry trades, reminiscent of the 2015 yuan devaluation or the 2018 U.S. repo market stress.
The BOJ’s next policy meeting, scheduled for June, will be closely watched for any updates to the reduction schedule. For now, the central bank appears committed to the path laid out by its governor, but whether it can sustain the tightening without breaking something remains the open question.
