A fresh wave of volatility in Japan’s government bond market is unsettling investors worldwide, amid signs of weakening demand for long-dated debt and growing concern over the broader implications for global financial markets.
For decades, Japan’s $7.8 trillion bond market was viewed as one of the most stable in the world.
But that status is now in question. In recent weeks, auctions for 20- and 40-year Japanese government bonds have recorded some of their weakest demand in years.
The rout has intensified since US President Donald Trump reintroduced tariffs under his “Liberation Day” plan in April, adding pressure to already fragile global bond markets.
Yields on 40-year government bonds hit an all-time high of 3.689% last week and were last seen at 3.318%, nearly 70 basis points higher since the start of the year.
Similarly, 30-year yields have jumped more than 60 basis points to 2.914%, while 20-year notes are up over 50 basis points.
Why is demand for Japanese government bonds falling?
Much of the anxiety stems from the Bank of Japan’s ongoing efforts to reduce its outsized presence in the domestic bond market.
Japan’s central bank has long played a dominant role in the domestic bond market, amassing vast holdings of government debt as part of its fight against persistent deflation — a battle that began in the 1990s during what became known as the “Lost Decades.”
But with Japan now gradually emerging from deflation, the BOJ is shifting course.
No longer focused solely on economic stimulus, the central bank is moving to scale back its massive balance sheet.
After its holdings of government debt hit a record high in November 2023, the BOJ has since pared back by ¥21 trillion ($146 billion) and has been reducing its quarterly bond purchases by ¥400 billion.
Source: Bloomberg
The central bank scaling back its bond purchases has prompted a key question: who will step in to buy if not the BOJ?
A disappointing 20-year bond auction on May 20, followed by weak demand for 40-year bonds on May 28, have underscored the risks.
Japan’s Finance Ministry is now said to be seeking feedback from market participants on whether to adjust the issuance of longer-maturity debt, highlighting rising concerns within government circles.
Investors are increasingly nervous that Japan’s bond market woes could set off a global ripple effect, particularly through the channel of capital flows.
Rising yields spark fears of Japan offloading US bonds
The sharp uptick in Japanese yields threatens to undermine the popular yen carry trade, in which investors borrow in low-yielding yen to invest in higher-returning foreign assets, often in the US.
Deutsche Bank AG has warned that rising Japanese yields would make bonds more attractive to local buyers and, as a result, could cause investors to pull out money from US debt.
According to Macquarie analysts, a “trigger point” may emerge where the yield gap closes enough to make domestic bonds more attractive than US assets.
Societe Generale strategist Albert Edwards warned in a CNBC report that such a development could spark a “global financial market Armageddon,” particularly if it hits US technology stocks, which have benefited from strong Japanese investor inflows.
The strengthening yen — up more than 8% this year — would only accelerate the shift.
“Tightening global liquidity will reduce world growth to 1% and by raising long term rates it will tighten financial conditions and extend the bear market in most assets,” he said.
This repatriation of funds to Japan is synonymous with the “end of US exceptionalism” and is mirrored elsewhere in Europe & China,” Roche added.
Source: Bloomberg
Strategists fear repeat of August’s carry trade unwind
The last major unwind in yen carry trades occurred in August 2024, when the BOJ surprised markets by raising interest rates.
The yen surged, and global markets slumped as investors rushed to close out positions.
Now, some strategists fear a repeat.
Natixis economist Alicia García-Herrero said the coming unwind may be even worse.
However, others suggest that the carry trade this time is on shakier ground to begin with.
Guy Stear at Amundi points out that the yield differential between Japanese and US 2-year bonds has narrowed from 450 basis points last year to around 320 basis points now, making the incentive for shorting the yen less compelling.
“Big carry positions typically build up when there is a strong FX trend, or very low FX volatility, and [when] there is a big short term interest rate differential,” said Guy Stear, head of developed markets research at Amundi.
Riccardo Rebonato, professor of finance at EDHEC Business School told CNBC he saw a “progressive erosion” over a long period of time rather than an implosion.
US asset exposure still favours equities
Despite rising fears of a capital pullback, some analysts believe Japan’s large holdings of US Treasuries — long seen as a stabilizing force — are unlikely to be dumped en masse.
Masahiko Loo of State Street Global Advisors said these holdings are “structural” and part of the broader US-Japan alliance.
Data from State Street also show that Japan’s exposure to US assets is heavily tilted toward equities, with nearly $18.5 trillion in stocks compared to $7.2 trillion in Treasuries.
According to Apollo’s chief economist Torsten Slok, any capital flight would likely begin with equities, then move to corporate bonds — not Treasuries.
Still, concerns about Japan’s ballooning debt remain.
Prime Minister Shigeru Ishiba recently compared the country’s fiscal position to that of Greece, sparking renewed scrutiny over whether the government can sustain rising borrowing costs.
All eyes on the BoJ to turn things around
In a sign of growing pressure, major life insurers and pension funds have asked the Bank of Japan to take stronger action to stabilize the bond market.
The BOJ is set to review its bond purchase plans in June, and Governor Kazuo Ueda has pledged to monitor market developments closely.
Meanwhile, the Finance Ministry’s move to consult market participants on super-long bond issuance signals that authorities are grappling with how to restore balance to a market once defined by stability.
With the prospect of capital flight, strained foreign exchange markets, and rising global yields, Japan’s bond market has transformed from a haven of calm into a potential source of global disruption.
Investors will be watching closely to see whether the world’s most indebted developed economy can weather the storm — or whether the fuse has already been lit.
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