A supplier of shocks: why Japan's market problems threaten investors around the world

The Japanese market has played a crucial role in international investment for decades as a source of ultra-cheap loans. But the situation is changing. Interest rates in Japan are rising, long-term bond yields are approaching the level of other developed countries, and the country's authorities are trying to support the yen. All of this could lead to a large-scale outflow of funds from global markets.

Since the 1990s, when the financial crisis plunged Japan into years of deflation, the country's interest rates have remained near zero (and in negative territory since early 2016). The Bank of Japan also pioneered quantitative easing - buying up government bonds to keep their yields low. These actions led to the devaluation of the yen.

As a result, Japan became the most popular market for carry trades, where investors borrow cheaply in one country and invest in higher-yielding assets in other countries. Such operations supported the growth of assets in other countries, especially in the U.S. market, both in stocks and bonds.

Only Japanese investors, primarily long-term investors, have about $5 trillion placed abroad, Bloomberg notes. And there are many other foreign investors who borrow in Japan to invest in other markets. Therefore, a significant change in the situation with the level of interest rates, which began to grow rapidly, and the exchange rate in Japan can radically affect international investment flows.

For this reason, the events of the past two weeks in Japan have weighed heavily on investors.

The country's Prime Minister Sanae Takaichi, who takes over as head of government in October 2025, has called a snap election for Feb. 8 in hopes of boosting support for her party.

The country's fiscal and monetary authorities were able to defeat def lation after years of effort. But now the Japanese are facing a new reality: the rising cost of living. Core inflation (net of energy and food prices) was 3.1% in 2025, exceeding the Bank of Japan's 2% target for the fourth consecutive year.

So Takaichi, on the eve of the election, promised to suspend the sales tax for food for two years and increase government spending.

This triggered a panic in the government bond market, which some participants compared to the crisis in the UK in 2022: then Prime Minister Liz Truss' decision on a large-scale fiscal stimulus caused a sharp drop in government bond prices and a collapse of the pound, and she had to leave office a month and a half after taking office.

"The danger is that Japan was a market that never moved anywhere, and now we're dealing with spectacular volatility," Ugo Lancioni, a fund manager at Neuberger Berman, told Bloomberg. - The market will eventually find a balance, but so far it doesn't seem to have happened yet. "You could call it the '[Liz] Truss moment,' where currencies are falling and long-term bond yields are somewhat out of control."

Takaichi came to power promising to pursue stimulative fiscal policy, as her mentor Shinzo Abe did during his 2012-2020 premiership. But Abe acted during a period of deflation, and Takaichi's promises put the Bank of Japan in a difficult position, which is already raising interest rates to curb inflation. Along with rates, government bond yields are rising, which increases the cost of servicing government debt - the world's largest (nearly 230% of GDP).

Since October, the yield on 30-year government bonds has skyrocketed by 75 basis points. By comparison, it took more than a year for it to rise by the same amount before Takaichi came to power, Bloomberg notes. According to Shinji Kunibe, a leading portfolio manager at Sumitomo Mitsui DS Asset Management, the government's actions have begun to undermine confidence in fiscal policy.

On Jan. 20, yields on 30-year securities soared to 3.88% from 3.61% the day before, and 40-year yields soared to 4.215% (the highest since their introduction in 2007) from 3.945%.

A quarter percentage point jump in yields "in a single trading session is something that is hard to comprehend," says Pramol Dhawan, a fund manager at Pimco, the world's largest bond fund management company. Until recently, such a move would have taken weeks, if not months.

Along with bond prices, which change opposite to the movement of yields, the Japanese currency fell to almost 160 yen per dollar, the lowest in a year and a half. This sparked speculation about the possibility of a joint intervention by the US and Japan to support it. They were fueled by reports that the Federal Reserve Bank of New York sent a request for yen quotes to currency market participants on January 23. That day the Japanese currency jumped by 1.7% (the maximum for almost six months). On January 28, U.S. Treasury Secretary Scott Bessent, however, said that the U.S. "absolutely does not" interfere in the situation on the yen market. But the Japanese national currency continued to strengthen, and on Friday was worth 154.3 yen per dollar.

The Bank of Japan itself intervened twice in 2024 when the nation's currency weakened to around 160 yen per dollar, the Financial Times notes. This was one of several factors that triggered the strengthening of the yen, the massive closing of carry trade positions and the short-term collapse in global equity markets in August of that year.

The possible repetition of this situation has now been joined by an even more powerful factor - high interest rates. Participants of the world market are beginning to realize more and more clearly that in the long term they may encourage Japanese investors to return money to the domestic market. And this will deprive foreign markets of support, Bloomberg writes.

Some are already ready to do so, especially since the yield on 30-year Japanese bonds is already higher than, for example, German bonds. Arihiro Nagata, global markets director at Sumitomo Mitsui Financia lGroup, Japan's second-largest bank, said he will double his investments in his country's government bonds from the current $67 billion: "I always liked investing in foreign bonds, but not anymore. Now I prefer Japanese ones."

"This is a new era," Masayuki Koguchi, CEO of fund management at Mitsubishi UFJ Asset Management, one of the country's largest investment firms, told the agency. In his view, Japanese bond yields have not yet risen high enough to stimulate a large-scale overflow of investment, but still, he says, "this is just the beginning - there is a possibility that there will be bigger shocks."

The jump in Japanese government bond yields was reflected in other markets. Bessent at the World Economic Forum in Davos even called his Japanese counterpart Satsuki Kitayama, reporting that the fall in the Japanese market was being felt in the U.S. Treasury bond market.

Goldman Sachs analysts wrote last October that Japan has become a "net exporter of bearish shocks" to global long-term bond markets in 2025. According to their estimates, with each such shock, if yields on long-term Japanese bonds rise by 10 bps, yields on government bonds in other developed countries, such as the US, Germany, and the UK, rise by 2-3 bps.

And if the yen is also falling, Japan must defend it. The quickest way to do that is to sell reserves, including U.S. Treasuries, says Anthony Doyle, chief investment strategist at Pinnacle Investment Management: "That's how Japan's problem turns into a rise in U.S. bond yields at the worst possible time."

If the monetary authorities' defense of the yen and the spillover to the Japanese market causes it to strengthen, it will severely undermine the possibility of a curry trade.

The cheap yen has been "one of the last strongholds" of such operations globally, says Naomi Fink, chief global strategist at Amova Asset Management, one of Japan's largest asset managers. If the Bank of Japan also accelerates rate hikes, all of these factors could drive down prices of risk assets globally as funds flow out of them to Japan, she said.

This article was AI-translated and verified by a human editor