The Implications of the Japanese Bond Markets

Japan's Bond yields are at record highs amid investor concerns over Prime Minister Sanae Takaichi's expansionary fiscal policy. The bond market is very telling, so here's what it means for the global economy.

The Background

• The Japanese bond market is the second biggest bond market in the world, amounting to over $7 trillion in debt.

• More importantly, Japanese investors are the largest foreign holders of US Treasuries, with holdings of around $1.2 trillion.

• Consequently, this means whatever turmoil happens in Japan also reflects in the US, potentially shaping global interest rates and thus every other asset class.

What's Happening in Japan Right Now

Japan's 40Y bond yields are at 3.95% and the 3Y yields are at 3.65% - the highest its been since 2007. The catalyst? - Prime Minister Sanae Takaichi announced a snap election (scheduled for February 8) alongside proposals to eliminate the 8% sales tax on food and expansionary policy. Without a clear funding mechanism for the tax cut, investors began pricing in higher government borrowing and, consequently, more bond issuance. Finance Minister Satsuki Katayama's calls for calm helped stabilise yields somewhat, but the underlying dynamics remain firmly in place.

The Carry Trade: Japan's Hidden Export to Global Markets

What is the Yen Carry Trade?

For years, Japan's interest rates were often near zero or even negative. This creates the opportunity for global investors to carry trade: borrow in yen at negligible rates, convert to dollars or other currencies, and invest in higher-yielding assets. The spread between Japanese and US rates represented "free money" for those willing to take on currency risk.

The proceeds from these carry trades flowed into US Treasuries, corporate bonds, real estate, and even US equities.

In some ways, the Nasdaq became a leveraged bet on the yen staying weak and Japanese rates staying low. We saw this relationship laid bare in August 2024. When the Bank of Japan hiked rates and signalled a departure from ultra-loose policy, the yen appreciated sharply, jumping from above 160 to below 145 against the dollar in just weeks. The Nasdaq-100 fell 13% in less than a month. The Nikkei 225 plummeted 12.4% in a single session, its worst day since 1987.

The mechanism was simple - as yen borrowing costs increased and the currency appreciated, carry trade positions became unprofitable quickly. Investors scrambled to unwind by selling their most appreciated assets (US equities) to repay the yen-dominated loans. causing cascading liquidations across global equity markets.

Why This Time Could Be Different & Consequential

• Rising Bond yields reduce the incentive for Japanese capital to flow abroad. When domestic bonds offered near-zero returns, Japanese institutions,pension funds, insurers, banks,had little choice but to seek yield overseas. Much of this found its way into US Treasuries. But with 10-year JGB yields now above 2.2% and 30-year yields near 3.7%, the calculus has shifted. Japanese investors can increasingly find acceptable returns at home, particularly when factoring in currency hedging costs.

• Fiscal concerns are intensifying. Japan's debt-to-GDP ratio stands at 237%, the highest among developed economies. The government hasn't run a budget surplus since 1990. Demographic headwinds,an ageing population, shrinking workforce, make deficit reduction structurally challenging. Prime Minister Takaichi's proposed tax cuts, without clear offsetting measures, have raised legitimate questions about debt sustainability.

• Foreign participation has surged. Overseas investors now account for roughly 65% of monthly cash JGB transactions, up from just 12% in 2009. While this has brought liquidity, it also introduces the risk of rapid, coordinated selling if sentiment turns. The "liquidity vacuum" that emerged during recent sell-offs,where electronic trading became difficult due to one-sided selling pressure, highlights this vulnerability.

The Link Between Japan and the US

Japan holds approximately $1.2 trillion in US Treasuries. And of course, that means the US Treasury market and the US interest rate structure, and therefore the global interest rate structure, is incredibly sensitive to what the Japanese are doing with regard to their holdings of US Treasuries. Any upward pressure on Japan's borrowing costs puts pressure on the US and we seen this happen as we've already seen US 10-year Treasury yields rise in tandem with JGB yields this week.

The US-Japan rate spread has historically been a key driver of capital flows. As this spread narrows,whether through BOJ hikes or Fed cuts, the incentive structure for global capital allocation shifts. Money that once reliably flowed from Tokyo to New York may find new destinations or simply stay home.

Regarding the carry trade, conservative estimates put the yen carry trade complex at roughly $1-2 trillion. While not all of this will unwind, even partial deleveraging creates selling pressure across asset classes. The August 2024 episode demonstrated how quickly this can unfold and how correlated previously uncorrelated assets can become during stress.

Investment Implications

For equity investors, particularly those with large stakes in US technology companies, the Japanese bond market is one to watch. The recent strength of the association between yen moves and Nasdaq results is undeniable, with the link now much more robust since 2024. Large increases in the yen due to policy, politics, or risk-off events can trigger waves of selling, with momentum stocks feeling the pain the hardest.

Higher JGB yields mean opportunities and risks for fixed-income investors. The opportunities in Japan are becoming an increasingly attractive option for higher yields and hedging currency risk. The risks of U.S. yields rising if Japan continues selling U.S. Treasuries.

Macro strategists are presented with opportunities by the mix of BOJ policy, Japanese fiscal policy, and global capital flows. The election on Feb 8 is a significant event, as a decisive election for Takaichi could propel fiscal expansion, while a hung parliament provides a short-term relief.

Bottom Line

For most market participants, Japan remains "background noise." But for professionals and serious students of markets, it's front and centre. The speed of current moves isn't yet aggressive enough to force immediate portfolio action, but it's reaching levels that are grabbing the attention of global investors.

Disclaimer: This article is for educational purposes only and does not constitute financial advice. Always conduct your own research and consult with qualified professionals before making investment decisions.