Japan is a country that has a tendency to return to the spotlight from time-to-time, but usually for the wrong reasons. The economy of Japan is suffering from some underlying issues.
Its debt is large and its growth is modest.
In a single session, the yields on long-dated government bonds jumped by over a quarter percentage point. The yield on the 40-year bond also crossed 4% for first time since the bond was issued.
This has shaken the markets. Domestic insurers have sold aggressively and global yields have moved higher in just a few hours. Investors who had stopped paying any attention to Japan were shocked.
The market has now started to price Japan again.
How did Japan get here?
Japan’s public deficit has been extreme for many years. Gross government debt is near 240-250% GDP, which is far higher than the US or Europe. This is not a new phenomenon. The environment in which it is situated is what is new.
The Bank of Japan artificially kept the cost of long-term borrowing low for most of the last decade through heavy bond purchasing and yield caps.
The result was stability as yields on ten-year bonds hovered around zero, ultra-long-term bonds traded within narrow ranges and debt service costs were manageable despite the size of borrowing.
This system has been loosening up since 2024. The central bank has loosened its market footprint, allowing yields to move more freely.
Inflation has returned and nominal growth has increased, pushing yields up even without tightening policy.
Then came the politics. The government announced a large package of fiscal measures and a suspension of the food tax for two years, a move that is estimated to cost approximately Y=5 trillion (32 billion dollars) per year.
The prime minister presented a snap election to be a mandate for policy changes.
Officials claimed that the measures would not require any new borrowing but provided few details.
The markets did not wait to be clarified. They priced the risk.
Why did the bond markets react so violently?
The market structure is easy to understand once you know the mechanics.
The price of ultra-long bonds is not based on the central bank’s expectations. They are traded on the basis of supply, demand and long-term creditworthiness.
When investors expect or even suspect more issuance to occur, yields will adjust quickly.
Demand has also changed. The Japanese pension funds and life insurers that absorbed the majority of new issuance are now starting to change.
In December, insurance companies sold a record number of bonds with long maturities. When yields started to rise in early January, there were no stable buyers.
Foreign investors now dominate the marginal trading of Japanese government bonds.
They are the majority of the cash market participants and they use leveraged strategies linked to global rates and yen.
These investors will exit quickly when the price moves against them. When yields spiked, leverage was reduced, positions were unwound and liquidity disappeared.
A weak auction for bonds with a 20-year maturity date was more of a confirmation than a cause. By the time the auction was over, the market already had lost confidence in the long-term.
Why the BOJ didn’t stop it
Investors assumed that the central bank would act quickly in past stress episodes. This time it didn’t.
This restraint was deliberate. After years of distorting bond markets, the Bank of Japan is trying to restore some level of price discovery.
Officials have repeatedly stated that emergency tools are still available, but they are not meant to be used for every unpleasant repricing.
Stepping in too soon would have undermined a message that Japan was returning to a normal market framework. The absence of immediate intervention has changed the behavior from a market perspective.
Traders are no longer assuming that there is a buyer below them.
Once this assumption was disproved, yields rose to levels that private investors were willing and able to hold. This level was above 4% for 40-year bonds.
Why Japan’s move has affected global markets
The Japanese bond market is not an island. It is at the heart of many global mechanisms.
First, Japan anchors the global duration. When Japan’s long-term yields increase sharply, relative value trades force the sale of other sovereign markets. On the same day that Japanese yields soared, US 30-year Treasury rates rose to 4.9%. European bonds also moved.
Second, the yen is still a funding currency. Carry trades that rely heavily on yen borrowing at low cost are put under pressure by rising Japanese yields and the weaker yen. As these trades unwind they put pressure on spreads for equities and credit, as well as emerging markets.
The recent cross-asset nature confirms this.
Third, Japan is viewed as a stable country. Investors reassess their risk exposure when this perception cracks. The result is a wider tightening of the financial conditions, not just a Japan-only selling-off.
What investors can actually learn from this
Japan’s situation has often been framed as extremes. Either Japan is described as immune to market pressure or on the brink of collapse. The evidence does not support either view.
The recent bond market shock was not indicative of default risk. Japan’s debt is largely held domestically, and the government has significant fiscal capacity. The pricing was the only thing that changed, not the solvency.
The real lesson to be learned is much simpler and more important. Japan is no longer immune to market discipline. Long-term rates can move quickly.
Fiscal signals are now important. Foreign capital sets the prices at the margin. Volatility, which was previously absorbed by the policy, now passes to the markets.
Investors ignored Japan for years because nothing happened. This era is over.
Japan is no longer irrelevant, not because the country is about to fail but because its repricing feeds into global rates and risk appetite.
When a long-held assumption ceases to hold, markets rarely warn in a gentle way. In January, Japan’s bond market didn’t whisper. Global investors heard it loud and clear.
This post Should investors be worried about Japan’s bond markets again? This post may be updated as new information unfolds
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