SocGen: Don't let the shutdown distract you from Japan
While the U.S. government shutdown and impending debt-ceiling debate has investors transfixed, they need to keep an eye on developments in Japan, warns Societe Generale's strategist Albert Edwards.
Edwards said in a note that a recent decline in the benchmark 10-year Japanese government bond (JGB) yield below 0.65 percent - not far from all-time lows of 0.43 percent - could be a worrying sign for Japan as well as global markets. The benchmark 10-year yield was trading at 0.657 percent on Friday.
"We believe it is always worth keeping a close eye on events in Japan, not just for its own sake, but for what that might mean for the wider global economy and markets," said Edwards.
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Japan is the world's third-largest economy and is home to one of the one of the world's biggest government bond markets. What happens in the JGB market can have wider implications for global markets.
This year, Japanese policy makers have embarked on an ambitious attempt to revitalize its beleaguered economy through aggressive monetary easing, fiscal stimulus and structural reform. So far, the policies have given Japan a boost. The economy grew at a healthy annualized rate of 3.8 percent in the second quarter of this year, following 4.1 percent growth in the first quarter.
However, Edwards said the decline in bond yields could be a sign that Prime Minister Shinzo Abe's decision to push through with a planned sales tax hike is a repeat of past mistakes.
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This week Abe confirmed that the scheduled tax hike, which will see the consumption tax rise from 5 to 8 percent in April. The last time the tax was hiked in 1997 it was blamed for pushing Japan back into a recession.
"The recent decision to press ahead with the rise in the consumption tax from 5% to 8% in April next year is seen by many as a major policy error," he said.
(Read more: Japan's Abe calls for cut in corporate tax rate)
The JGB bond rally could have broader implications for the rest of Asia, emerging markets and U.S. Treasurys, added Edwards.
If the BOJ undertakes more monetary stimulus to offset the impact of the sales tax on the economy, it could weaken the yen and subsequently lead to strength in other Asian currencies, hurting the global economic recovery and depressing U.S. bond yields, said Edwards.
"In my view we are quickening the pace towards losing control of both the Japanese currency and inflation," said Edwards.
"We reiterate our view that any decline in the yen at this time will echo the 1996-1997 period where yen weakness put a severe strain on other Asian countries' balance of payments and contributed in large part to the 1997 Asian currency crisis," he said, adding that he expected the yen weakening trend to lose control over the next year as the BOJ ramps up Quantitative Easing.
(Read more: Japan's consumer inflation rises to 5-year high)
"The impact of this on the West is not rocket science. There have only been two occasions when U.S. implied inflation expectations have turned negative: the 2008 in The Great Recession and 1998, in the wake of the Asian crisis," he said.
—By CNBC's Katie Holliday: Follow her onTwitter @hollidaykatie