All gains in the S&P 500 index this year have been erased. After Nvidia (NVDA.O) released its earnings report and outlook, investors again felt uneasy about the valuations of large tech companies. Layoffs driven by the Trump administration's Department of Government Efficiency (DOGE) and economic uncertainty brought about by tariff rhetoric have shaken traders' confidence.

Meanwhile, Dhaval Joshi, Chief Strategist for Reverse Global Macro Services at BCA Research, pointed out that another potential danger may sow the seeds for the next financial shock. His concerns focus on the differing inflation curves between the US, UK, EU, and Japan.

As the US and UK economies slow down, both countries are vulnerable to what Joshi calls 'mini-stagflation.'

"Inflation expectations in the US and UK are above average, while inflation expectations in the eurozone and Japan are in line with the average, which has significant implications for relative central bank policies. Worryingly, this also sows the seeds for the next financial shock," Joshi stated.

The problem is that among the three major economies' central banks, only the Bank of Japan is in a tightening cycle. "As inflation expectations return to 2%, the zero interest rate policy is no longer applicable. The Bank of Japan must quickly normalize interest rates to its estimated neutral level of 1-2.5%," Joshi explained.

Bank of Japan Governor Kazuo Ueda stated that the Bank of Japan must carefully consider the developments in the overseas economy, especially the US economy, and their impact on financial and foreign exchange markets.

In other words, when 'mini-stagflation' occurs, the Fed's potential pause in rate cuts makes it easier for the Bank of Japan to achieve interest rate normalization.

This is a problem for Wall Street. Joshi and others believe that an important arbitrage trade in recent years has been borrowing cheap yen to buy US stocks related to AI. "Japan's real negative interest rates have inflated the AI bubble. Therefore, the normalization of Japanese interest rates is a key potential factor in bursting this bubble," he said.

Joshi noted that AI stocks and yen arbitrage trades are correlated, which means investors need a financing currency (yen) with a stable low or negative yield to invest in a stable high-yield investment destination (AI stocks).

"Therefore, the bubble could burst: either the stable low yields of yen financing come to an end; or the enthusiasm surrounding AI stocks is broken," he argued. He studied data since the beginning of 2023 and found an inverse correlation between Microsoft's (MSFT.O) valuation and Japan's 10-year real bond yields.

Therefore, the normalization of Japan's real bond yields will impact the US stock market.

A simpler tracking method is to observe the USD/JPY exchange rate. "If the USD/JPY exchange rate falls below 145, it is almost certain that global stock markets will also face a bearish trap." Currently, this exchange rate is slightly above 150.

Joshi suggests that investors should overweight yen; underweight euro; and underweight US stocks in global portfolios.

The article is reposted from: Jinshi Data.