Japan loses control, leaving investors on high alert

Japan is experiencing one of the biggest upheavals in its bond market, with yields reaching levels not seen in many years, leaving investors apprehensive and markets nervous. This Tuesday, the yield on 30-year Japanese Treasury bonds reached an all-time high of 3.22%, while the 10-year bond climbed to 1.595%, the highest level since July 2008. About a year ago, in early August, it was trading below 0.8%.

This escalation in the price of Japanese debt is sending shockwaves through global debt markets and raising serious questions about the sustainability of the public finances of the country with the highest debt ratio in the world, which had public debt equivalent to approximately 216.2% of GDP at the end of last year, more than double the national wealth created annually.

This seemingly technical movement in the market actually hides a profound transformation that could redefine the balance of the Japanese economy, and also of global markets.

Japan, which for decades has been a major lender of US debt and a pillar of stability in global bond markets, is now at the center of a perfect storm combining domestic budgetary and fiscal pressures, political uncertainty, and a fundamental shift in the Bank of Japan's monetary policy.

The rise in the yield on US Treasuries, which this Tuesday reached above 5% again for 30-year bonds, is largely a "byproduct" of the turbulence in the long-term Japanese bond market.

The current crisis stems from a series of interconnected factors. The first destructive element is the political uncertainty generated by the elections taking place this Sunday , with polls indicating that Prime Minister Shigeru Ishiba's governing coalition could lose its parliamentary majority. This prospect is spooking investors because opposition parties have promised substantial consumption tax cuts and more expansionary fiscal policies.

" There's no doubt that the government's fiscal policy after the election will have a significant influence on the future direction [of Japanese government bonds] ," warned Ataru Okumura, senior interest rate strategist at SMBC Nikko Securities. The market is particularly concerned about scenarios that could have a significant impact on the bond market, such as the consumption tax cuts advocated by several political parties.

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Inflation is the second pillar of this crisis. The price of rice, a staple of the Japanese diet, has soared more than 100% in the last year, contributing to an underlying inflation rate (excluding unprocessed food and energy products) of 3.7% in May, the highest level since January 2023. This inflationary surge is putting pressure on the Bank of Japan to maintain a restrictive monetary policy, at a time when other central banks are considering interest rate cuts.

"The Bank of Japan is currently the only major central bank that appears to still be on a path to monetary tightening," Banco Carregosa states in its latest outlook for the rest of the year. The institution led by Kazuo Ueda raised interest rates from 0.25% to 0.5% in January 2025, the highest level in 17 years, and has remained at that level ever since.

However, analysts expect one more hike in 2025 and two in 2026, which would imply a terminal rate of at least 1.25%. The Bank of Japan's next monetary policy meeting will take place later this month, on July 30th and 31st, at the same time that it will also publish new economic forecasts, which are expected to show an upward revision to inflation.

When Tokyo sneezes, the world catches a cold.

The rise in Japanese yields is having an unprecedented global impact on debt markets. In a note to clients at the end of May, Goldman Sachs analysts estimated that the wave of investor selling in 30-year Japanese Treasury bonds was contributing to an increase of around 80 basis points in yields in several countries, notably the United Kingdom and the United States.

This means that the rise in US Treasury yields , which this Tuesday once again traded above 5% for 30-year bonds, is largely a "byproduct" of the turbulence in the long-term Japanese bond market. And according to Blackrock, the world's largest asset manager, this trend isn't expected to stop there.

In their latest outlook for the next six months, analysts predict that there is still " room for yields to rise further due to rate hikes from the Bank of Japan and a higher global term premium ." For the rest of the world, this reality translates into a contagion effect that operates through various channels and with distinct implications for investors' portfolios and countries' public finances.

• Japan is the largest foreign holder of U.S. Treasury bonds , with $1.1 trillion in securities—equivalent to a quarter of Japan's GDP. Thus, any pressure on Japanese finances could lead to a reduction in these holdings to defend the yen or finance domestic deficits, which would further push up U.S. bond yields as a result of a selloff in these securities by Tokyo.
• According to a recent analysis by Bloomberg analysts, U.S. Treasuries have become more sensitive to movements in Japanese bonds , especially since the Bank of Japan began abandoning yield curve control in 2022. This increasing correlation means that volatility in the Japanese market is transmitted directly to U.S. markets.

All of this data points to the end of an era of extremely low Japanese bond yields lasting more than two decades. The Bank of Japan's abandonment of yield curve control in March of last year and the start of a quantitative tightening policy eliminated the artificial support for Japanese bond prices. Now, market forces are determining prices, and the result is a structural rise in the Japanese Treasury's borrowing costs .

Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management, believes that if the government coalition loses its majority in Parliament, the yield on the 10-year bond could rise to 1.8%, the highest level since mid-2008. "This indicates how fiscal health has deteriorated and prices have risen since then," the analyst told Reuters , also noting that "the Bank of Japan holds about half of Japanese government bonds and this has limited the rise in yields ."

Japan's current crisis, therefore, represents much more than a domestic problem. It is a turning point that could redefine global capital flows, force a reassessment of sovereign risk, and mark the beginning of a new era of higher yields in global debt markets.

The Bank of Japan currently holds about half of all outstanding Japanese Treasury bonds. However, it is now implementing a quantitative tightening program , gradually reducing its monthly bond purchases by 400 trillion yen (about €2.3 billion) per quarter, aiming to cut monthly purchases to 3 trillion yen (about €17.4 billion) by March of next year. This gradual withdrawal of the market's largest buyer is creating a fundamental imbalance between supply and demand.

This transformation has profound implications for global equity markets. Historically, when bond yields rise significantly, money tends to flow from equity markets to debt markets, especially if investors perceive attractive returns with lower risk. Rising Japanese yields could therefore create downward pressure on equity indices, not only in Japan but globally.

The situation is particularly worrying because, as Banco Carregosa notes in its outlook for the rest of the year, " Japan continues to demonstrate the return of inflation and monetary policy to areas of normality, but which had been elusive for several decades ." This normalization is occurring "precisely at a time when other central banks are loosening monetary policy," creating a policy divergence that could amplify volatility in global markets.

Japan's current crisis, therefore, represents much more than a domestic problem. It is a turning point that could redefine global capital flows, force a reassessment of sovereign risk, and mark the beginning of a new era of higher yields in global debt markets. For investors and global markets, this means that Japan is no longer the safe haven of low, predictable yields it was for decades.