Japan versus the world - why bond markets have never been more exciting

Some bond market participants are concerned that the rise in Japanese government bond (JGB) yields is a bearish sign for global fixed income. There are also concerns that factors driving up Japanese yields are at play elsewhere, namely inflation and fiscal risks. The most recent data points to Japanese inflation stabilising and the Bank of Japan (BoJ) keeping interest rates at 0.5%. While there are country-specific factors impacting most bond markets, global yield levels remain such that total returns are still likely to be positive for investors.

Misery is…

Bond investors worry about three things. These are: bonds being repriced by unexpected changes in central bank interest rates; inflation eroding the real value of bond returns; and increases in government supply – due to higher budget deficits - causing bond yields to move high enough to attract investors to buy the additional debt.

Currently, at least two of those three issues are evident across markets. In the case of Japan, the concern is that rising inflation (at last), a reducing BoJ balance sheet and changes in the structural demand for long-term government bonds are driving yields higher. This could mean that global capital flows will be impacted by higher Japanese yields – investors in Japan having more incentive to invest in their own market rather than overseas, and other investors having to close the ‘yen carry trade’. In short, higher Japanese bond yields are seen as a potential cause of higher global bond yields.

Bonds are bonds

Given the liquidity in government bond markets, the role of government bonds as so-called risk-free assets, and the mobility of capital, it is understandable how correlated yields are. It is also important to remember that Japanese yields have always been lower – a product of Japan’s prolonged disinflationary backdrop that followed the stock market crash and the property bubble bursting at the end of the 1980s. It has also been the market with the lowest level of yield volatility in the G7. I did a simple analysis of JGB yields: regressing the JGB yield on other government bond markets yields (US, Germany and the UK). The correlations are high and back-fitting Japanese yields based on the regression results produces a good approximation of the actual yield (changes in Japanese yields are explained mostly by shifts in global bond yields).

Until recently that is. Since the end of 2023, JGB yields have moved much higher than levels suggested by yields in other markets. The divergence coincided with the first BoJ interest rate adjustment. Since then, with Japan’s inflation rate gradually increasing, investors have taken the view that Japanese interest rates and bond yields cannot be as far below levels in other markets as they have been historically. The fact the BoJ – which did more quantitative easing than anywhere else – is now reducing its balance sheet and that Japanese insurance companies and pension funds are generating less demand for longer duration government bonds, is creating an idiosyncratic risk premium in the JGB curve.

Japan, as a country, is very asset-rich, having built up international assets over time because of its persistent current account surplus. But its government debt-to-GDP ratio is higher than any other G7 country (gross debt is equal to 216% of GDP, according to the OECD). This is an additional concern for the market. Rest assured though, there is no Japanese bond crisis, but local factors have become more dominant. This means investors need to pay more attention to Japan’s macroeconomic situation in case there are implications for capital flows and bond yields elsewhere, as Japanese investors are major creditors in US and European markets.

The unknown

Then there are specific concerns about US Treasuries. There were rumours in the middle of the week that President Donald Trump was about to fire Federal Reserve (Fed) Chair, Jerome Powell. It is no secret that Trump wants the Fed to cut rates. The panic scenario is that Powell is replaced by someone more subservient to Trump and all normal procedures for setting rates - Federal Open Market Committee analysis and voting - are upended. Such a scenario would see higher bond yields through a steeper curve, and a weaker dollar. Break-even inflation rates would rise further as well, as this would be a potentially inflationary situation. There would need to be a bigger risk premium in US rates given the uncertainty around monetary policy – with implications for yields elsewhere and exchange rates.

Bond party

For Japanese investors, it already makes sense to stay invested in their home market as the cost of foreign exchange (FX) hedging means yields from US Treasuries or European government bonds, hedged into yen, are below those available in the JGB market. The Bank of Japan overnight rate remains low – at 0.5% - which means there is a near 400bp annualised cost for Japanese investors to hedge their US currency exposure. In contrast, investors in Europe and the US can pick up additional yield by holding foreign exchange hedged positions in Japanese bonds.

Risks and opportunities

There are genuine concerns about inflation andabout the fiscal outlook.But at the same time, inflation in Europe is back to target and the newly strong euro is helping keep inflation under control. China has no inflation and is exporting deflation again as it ramps up exports to the rest of Asia and Europe to compensate for losing market share in the tariff-protected US. Differentials in inflation trends will play out in divergent return opportunities in global fixed income markets.

There are genuine concerns about structural changes in the demand for bonds, particularly longer duration assets. Yet, governments are responding by issuing fewer longer-dated bonds which might mean that the long end will start to offer relative (scarcity) value at some point. The demand for fixed income is huge because of the income opportunities available today and yields are at attractive levels. Buying duration on spikes higher in yield, for long-term investors, remains an attractive option if Trump refrains from upending the global monetary stability by violating the Fed and subordinating the fiat system to crypto. It has never been more exciting to be in the bond market.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 17 July 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.