The central bank of Japan faces a dilemma where high yields on government bonds are threatening to destabilize its normalization of policies.
The Bank of Japan has a stark decision to make: it can continue with its policy of increasing rates, at the risk of higher and higher yields and even lowering an already sluggish economy, or it can maintain, even reduce interest rates in order to promote growth that might spur further acceleration of inflation.
The Japanese government bonds have been soaring to new heights over the last month. The yield on the benchmark 10-year JGBs rose to 1.917 percent on Thursday, soaring to its highest point since 2007.
LSEG data reported that the 20-year yield, JGB, had increased to 2.936 percent, the highest point since 1999, and the 30-year yield rose to a record high of 3.436 percent.
Japan dropped its yield curve control program in March 2024, in which 10-year bond yields were pegged to approximately 10 percent, as part of its policy normalization that also saw the country eliminate the last negative interest rate regime in history.
Currently, as the nation considers higher rates when inflation has been continuing to grow, it has remained above the BOJ 2 percent target for over 43 consecutive months, and the threat of bond yields going even higher looms large.
Anindya Banerjee, the head of currency and commodities at Kotak Securities, informed CNBC that, “Inside India,” in case the BOJ goes back to quantitative easing and YCC to set a limit on bond yields, the yen will also deteriorate and contribute to imported inflation, which is already an issue.
An increase in bond yields implies an increase in the cost of borrowing in Japan, which puts an additional burden on the Japanese fiscal situation.
The second-largest economy in Asia already has the highest debt-to-GDP ratio in the world, with nearly 230 percent, as per the International Monetary Fund data.
In addition to that, a government that is about to launch its biggest stimulus package since the pandemic to reduce the cost of living and support the ailing Japanese economy, the fears of the soaring Japanese debt are even more detailed.
Magdalene Teo, who leads the fixed income research of the Asian market at Julius Baer, stated that the new debt issuance of 11.7 trillion yen to fund Prime Minister Sanae Takaichi is 1.7 times bigger than the one issued by her predecessor, Shigeru Ishiba, in 2024.
Teo said that “This highlights the difficulty the government faces in balancing economic stimulus initiatives with maintaining fiscal sustainability.”
An unwinding of yen-funded leveraged carry trades in August 2024, as a result of hawkish hikes in BOJ rates and poor macro news announced by the U.S., saw stocks around the world sell off, with the Nikkei in Japan plummeting by 12.4 percent in the worst performance since 1987.
Carry trade involves lending in a low-interest-rate currency and investing in high-yielding assets. The Japanese yen is the most commonly used currency to carry out such trades since the country has a negative interest rate policy.
Rising Japanese yields have now reduced that rate differentiation, raising the fear of another round of carry trade unwind and the repatriation of funds into Japan. Therefore, the experts believe that a repeat of the 2024 meltdown is unusual.
Senior Fixed Income Strategist at State Street Investment Management, Masahiko Loo, stated that “From a global perspective, the narrowing Japan–U.S. yield gap reduces the appeal of yen-funded carry trades, but we do not expect a repeat of the 2024 systemic unwind … Instead, anticipate episodic volatility and selective deleveraging, particularly if yen strength accelerates funding costs.”
Loo added that structural flows due to the retail placements of pension funds, life insurance, and NISA [Nippon Individual Savings Account] pin down the foreign holdings and make large-scale repatriation improbable.
APAC Rates Strategist at HSBC, Justin Heng, noted that the Japanese investors have not been keen on repatriating funds, but they have been net buyers of foreign bonds.
HSBC reported that in the first quarter of 2025, it bought 11.7 trillion yen overseas debt, far outpacing the 4.2 trillion yen bought in all of 2024.
Heng further added that “We expect the continued decline in hedging cost, as a result of further Fed rate cuts, will also likely encourage Japanese investors to take more foreign bond exposure.”
