Japan is discovering that there is no clean exit from decades of easy money.
A volatile yen, surging bond yields and a new prime minister promising fiscal largesse have turned monetary normalization into a delicate balancing act for the Bank of Japan (BoJ), and a growing risk for global markets.
Last week, the BoJ voted to keep its policy rate unchanged at 0.75%. In the press conference following the decision, Governor Kazuo Ueda acknowledged that "long-term interest rates are rising at a quite fast pace," adding that the BoJ "may conduct market operations flexibly to facilitate interest rate formation in the market in a stable manner."
The comments followed a volatile week in Japanese financial markets, as investors aggressively repriced both the yen and Japanese government bonds (JGBs).
Sharp swings in the yen have tended to coincide with more cautious market conditions, which have weighed on cryptocurrencies.
Episodes of yen strength are often associated with tighter funding conditions and a pullback in risk-taking, leading Bitcoin and other digital assets to fall alongside equities.
The trigger
While the underlying forces behind recent market moves have been building for some time, domestic politics triggered the latest bout of excess volatility. Newly elected Prime Minister Sanae Takaichi announced early last week her intention to dissolve parliament, formally following through a few days later.
The decision comes at a moment when Takaichi still enjoys strong public support, with approval ratings at 67%, although down from record highs of 75% in December. Her Liberal Democratic Party (LDP) governs with a slim majority alongside its coalition partner, the Japanese Innovation Party (Nippon Ishin no Kai). Takaichi appears to be betting that her personal popularity will translate into a stronger mandate.
In an effort to shore up public support, the Prime Minister has pledged additional fiscal spending as households continue to grapple with the effects of inflation.
Her government has unveiled a ¥21.3 trillion ($135.4 billion) stimulus package, designed in part to shield Japan’s export-dependent economy from the fallout of US tariffs while also boosting domestic investment. It has also proposed a two-year suspension of the 8% VAT on food products, a move that would add further strain to already stretched public finances.
The bonds
While Takaichi enjoys strong electoral support, markets have been far less enthusiastic about the arrival of Japan’s new Prime Minister.
Japan’s gross debt already stands at around 250% of GDP. Even after accounting for the government’s substantial financial assets, net debt remains close to 130% of GDP.
The prospect of expansionary fiscal policy at a time when inflation is hovering near target has heightened investor concerns about Japan’s fiscal trajectory, pushing JGB yields sharply higher. The move comes as the BoJ has stepped away from its long-standing yield curve control framework and has begun tightening its balance sheet.
Chart
The rise in yields reflects a combination of factors. The BoJ’s dominant role in the bond market has increasingly been replaced by international investors, who tend to be more sensitive to fiscal sustainability risks. At the same time, domestic pension funds have reduced purchases at the long end of the curve; a shift that is not unique to Japan.
More broadly, central banks generally avoid exerting direct control over long-dated yields, which are shaped by structural forces such as long-term inflation expectations, demographics, savings behaviour, term premia and fiscal sustainability.
As a result, yields on long-dated JGBs have surged above 4%, their highest level since 2007.
Power of a weak yen
Over time, a weak yen has provided important support to Japan’s finances.
Prolonged currency stability at relatively low levels, combined with steady depreciation against the US dollar over the past 15 years, has helped keep Japan’s export-driven economy competitive.
A cheap and stable yen has also facilitated the so-called carry trade, in which investors borrow yen to fund investments in higher-yielding overseas assets.
Chart
However, the yen’s persistent weakness has increasingly drawn the attention of the US administration. Last year, US Treasury Secretary Scott Bessent and Japanese Finance Minister Katsunobu Kato reaffirmed their shared commitment not to manipulate currencies for competitive advantage.
That said, the fiscal expansion proposed by the new Prime Minister has accelerated depreciation pressures. Last week, the yen was trading close to 160 per dollar.
The intervention that wasn’t
In a move widely interpreted as a warning shot to markets, the New York Fed contacted major financial institutions active in yen–dollar trading on 27 Jan for an exchange-rate "rate check." The gesture was intended as a signalling exercise on both sides of the Pacific.
Chart
On 25 Jan, Prime Minister Takaichi said her government would take "all necessary measures to address speculative and highly abnormal movements." Chief Cabinet Secretary Minoru Kihara added that Japan would work closely with the United States and act in line with the agreement reached by the two countries’ finance ministers last September.
Still, there are clear limits to how much official intervention can steer a currency in the desired direction.
As noted by Robin Brooks, former chief FX strategist at Goldman Sachs, currency intervention tends to be most effective in the short run when it is unexpected, and market positioning is stretched.
Neither condition currently applies to the yen. Over the medium term, fundamentals remain the dominant driver.
The positioning
Until recently, the BoJ had been actively suppressing government bond yields, and the process of yield curve normalization has inevitably come with a degree of volatility.
While Japan’s fundamental economic outlook is far from robust, it does not point to an imminent crisis.
Unlike the US, Japan runs a current account surplus, partly supported by the weak yen. It is also one of the world’s largest creditor nations. Japanese households, pension funds and institutions collectively hold trillions of dollars in overseas assets, giving the country outsized influence over global capital flows.
While the dollar has weakened against most G7 and emerging-market currencies, it has continued to strengthen against the yen, despite a narrowing interest rate gap as the BoJ hikes and the Federal Reserve cuts.
Japan’s excess savings, export-oriented economy and ageing population all make a weaker currency politically and economically convenient.
Domestic decisions, global risks
Japan’s unique position and immense financial clout mean that developments in the country's markets carry implications well beyond its borders.
First, there is Japan’s exposure to US Treasuries. Rising JGB yields increase the incentive for domestic investors to repatriate capital, given Japan’s substantial holdings of US government debt.
As those flows reverse, Treasury yields are pushed higher. According to Goldman Sachs analysts, every 10-basis-point "idiosyncratic JGB shock" translates into roughly two to three basis points of upward pressure on US, German and UK yields.
Second, if the yen were to slide further and the BoJ opted to defend it, intervention would likely involve selling foreign exchange reserves - including US Treasuries - adding another source of upward pressure on US borrowing costs.
The spillovers could extend beyond fixed income and currencies. If intervention weakens the dollar-yen rate during periods of geopolitical stress, it may amplify price spikes in dollar-denominated commodities such as gold and silver.
As the BoJ continues to normalize monetary policy while the government leans into fiscal expansion, Japan is likely to face an increasingly stark trade-off between higher bond yields and a weaker currency.
Much will depend on the outcome of the upcoming elections, but whatever path is chosen, the consequences will be felt well beyond Japan’s borders.
