What Japan’s bond market is telling investors and why you should be listening

Japanese long bond yields have a decided spring in their step, rising strongly in recent days and building on a year-long trend as inflation reasserts itself and the Bank of Japan slowly normalises short-term interest rates.

The source of the most recent jump can be traced to Japanese PM Sanae Takaichi calling snap elections for 8 February, hoping to capitalise on her popularity and cement a majority in the parliament. If successful, this might go some way to increasing political stability while at the same time feed growing angst as to the fiscal and monetary implications.

This is typified by rising bond yields at all tenors. For investors, this has immediate impact on bond prices, but over time, higher borrowing costs will be borne by the Japanese taxpayer. With Japanese government indebtedness already at 250% of GDP, any change in borrowing cost will swiftly translate into budget deterioration.

Figure 1: Japan bond yields

There is a saying in bond markets that “yields will keep rising until something breaks”. When yields rise quickly they have a habit of exposing vulnerabilities elsewhere in the system. Two recent examples include bank failures in 2023 (Silicon Valley Bank et al), and the UK pensions crisis of 2022.

In early 2023, several banks failed due to structural mismatches between bank assets that included low coupon, fixed rate debt and liabilities that were mostly deposits. Rising interest rates responding to inflationary impulses created losses that overwhelmed capital reserves.

Similarly in 2022, gilt yields responded violently to a UK mini-budget that created confusion and consternation. In doing so, higher rates revealed significant vulnerabilities in obscure hedging instruments tied to long-term interest rates and used widely in UK pension funds.

In both cases, conditional support was required from authorities to restore order, protect depositors and reassure bond markets.

We see parallels with Japan. Indeed, recent history includes periods of specialised quantitative easing known as yield curve control, as well as intervening directly in currency markets to defend the yen. In this case, however, risks have been building for decades and are systemically ingrained, making any solution a balance between stability and sustainability.

Despite high indebtedness and disinflation Japan was, up until recently, often sought out as a haven during geopolitical or economic uncertainty. However, over recent months precious metals have been the pre-eminent risk mitigation trade. Often seen as a hedge against inflation or geopolitical unrest, gold and silver are correlating closely with Japanese bond yields, with support from speculators via ETFs.

Figure 2: Safe havens, new and old

The challenges facing Japan are not new. What has changed is the environment in which these issues need to be considered. From a fiscal standpoint, the government has committed to more spending on defence and other initiatives to encourage growth, widening the deficit further. Meanwhile, the return of inflation is forcing monetary authorities to respond, albeit cautiously for now.

In our view, continuing to forestall meaningful action will only make the problem more intractable. In practice, there are only two options that should be considered – 1) defend the yen, raise interest rates and face a fiscal crisis, or 2) redouble QE/YCC, bring bond yields under control, and crater the value of the currency. Recent developments, including potential coordinated action to intervene and slow the depreciation of the yen, indicates authorities considering a version of option 1, with help from global partners including the United States.

Prime Minister Takaichi is fully committed to an ambitious spending plan, which includes sales tax reductions on politically sensitive items such as basic foodstuffs. In our view, if implemented this plan will only add fuel to the fire and make the ultimate decision more difficult.

A further complication arises in that more of the additional government debt to fund these spending promises will need to be taken up privately, given the Bank of Japan (BOJ) plans to keep slowly reducing its bond buying activity through 2026.

Figure 3: BOJ bond buying intentions

Implications for credit markets?

Based on the reaction of credit markets to date, one could be forgiven for thinking that there was no cause for concern. We can understand this to a certain extent, given the risks to corporate bond investors in Australia due to ructions in the Japanese bond market are nebulous at best.

But the Japanese are large global investors, having been forced to for decades. As local yields rise, the allure of repatriating funds and doing away with the need to monitor currency movements and hedging needs increases.

Furthermore, yield moves of the kind we are witnessing would be like kryptonite for carry traders. However, while the yen has been weakening against a trade-weighted basket and against USD for several years, there is little evidence of dislocation. This suggests to us that the once massive carry trade may not influence marginal currency levels or yields as in years past.

Figure 4: JPY exchange rate

In addition to US$1.2tn in sovereign bonds, Japanese investors are estimated to own approximately US$600bn of corporate debt. These investors would undoubtedly also be considering repatriation under the right circumstances. Most major credit markets are performing strongly, with spreads at or near cycle tights, so Japanese credit investors may find the repatriation decision a relatively simple one.

One caveat to this comes in the breadth of access to growth sectors available outside of Japan. Artificial intelligence is flying in the US. Defence industries have found a renaissance in Europe, and robotics, while huge in Japan, is also booming in China.

Credit markets have started 2026 on a strong footing, largely ignoring the precarious geopolitical environment and rising bond volatility, driven by key markets like Japan.

There are still many good reasons to remain positive for returns this year, but the evolving situation in Japan adds another vector of uncertainty.