Due to Donald Trump’s erratic policies, all eyes are on the United States bond market, where the bond vigilantes have run wild. But there is also unrest in the Japanese bond market—and perhaps that should worry us even more.
In August two thousand twenty-four, a shockwave rippled through the financial markets. The cause was Japan—more specifically, the Bank of Japan, which abandoned its rigid zero interest rate policy, in place since February nineteen ninety-nine, and raised rates to zero point two five percent. It also began to gradually scale back its massive purchases of government bonds (JGBs). This triggered alarm bells among speculators who had, for years, bet hundreds of billions of United States dollars on the Japanese carry trade.
The carry trade involves borrowing in a currency with low interest rates and exchanging it for currencies with higher rates, such as the United States dollar, the New Zealand dollar, or the Mexican peso. As long as the yen’s exchange rate remained stable, speculators pocketed the interest rate differential. And since the yen steadily depreciated, they also gained from currency appreciation. The Bank of Japan’s policy pivot threatened to make the carry trade less attractive, prompting traders to unwind their positions.
When it rains in Japan…
As often happens in financial markets, a self-reinforcing feedback loop emerged. Carry traders bought back yen to repay their debts, causing the yen to surge—by thirteen percent in a single month. This pushed other carry traders into trouble, facing heavy losses and inevitable margin calls. And just like that, markets were suddenly “on sale.” The storm passed relatively quickly, but the message is clear: when it rains in Japan, the rest of the world can get soaked.
Japan holds vast savings surpluses, managed by large institutional investors who have invested four thousand six hundred billion United States dollars abroad in search of yield. And “in search of yield” is not an exaggeration—Japanese government bonds, even with very long maturities, offered virtually no interest for years. But that situation has changed dramatically. Japanese long-term interest rates have soared.
In May, the yield on forty-year bonds hit three point seven percent—a record since this type of bond was first issued in two thousand seven. The yield on twenty-year bonds rose above three percent, its highest level in twenty-five years. While yields have since eased somewhat, they remain high enough to make Japanese government bonds attractive again to domestic investors. Meanwhile, the yen appears to have entered a structural upward trend.
Financial armageddon
In short, Japanese investors now have good reason to reduce their foreign holdings. And that matters for the United States bond market. Japan is the largest foreign holder of United States government debt. According to perma-bear Albert Edwards of Société Générale, “Trying to understand and track the rising long end of the Japanese bond market should be the number one priority for all investors.” He argues that a further rise in Japanese yields “could trigger a global financial armageddon.”
Japan is also the ultimate test case of how far a developed country can go in monetary and fiscal experimentation. Japanese government debt amounts to eleven thousand billion United States dollars, or two hundred fifty percent of gross domestic product—twice the United States ratio. To keep this debt affordable and discourage short selling, the Bank of Japan pulled out all the monetary stops and purchased half of all outstanding JGBs. As long as this did not lead to runaway inflation, Japan got away with it—helped by the fact that only twelve percent of its government debt is held by foreigners.
But the long period of low inflation is over. Japanese inflation has climbed out of the trough and now stands at three point five percent—well above the two percent target. Some hawks at the Bank of Japan are calling for further rate hikes. While it is unlikely that policy rates will be raised sharply, as in the West, the key question is whether—and for how long—Japan can endure high long-term interest rates.
For twenty years, Japan was able to finance its debt virtually for free. But if a long-term interest rate of around three percent gradually filters into average borrowing costs, and the debt level continues to rise, interest payments could reach ten percent of gross domestic product—in a country facing grim demographic trends. Edwards has been wrong before with his pessimism, but he has a point. As investors, Japan deserves our full attention.
Jan Longeval is founder of Kounselor Consulting and adjunct professor of finance at Vlerick Business School. He writes a monthly investment column for Investment Officer.
