- Yen weakness and rising JGB yields pose broader risks to global duration markets
- Japan’s high debt burden limits how aggressively the BOJ can tighten policy
- Capital repatriation could pressure US Treasuries via reduced Japanese demand
- Debt sustainability and inflation remain key headwinds; we prefer 5–7Y duration and A/BBB credit
Chaos theory. Over the last few weeks, Japan and the United States launched a rare joint currency intervention—the first major coordinated G7 action since 2011—spending nearly USD59bn to prop up the JPY after the currency hit 40-year lows. While seemingly unrelated, we believe this has material implications for the fixed income landscape. Now in case one thinks that we are greatly exaggerating causality, a little scrutiny reveals that such coordinated currency interventions across the Pacific are in great part to do with both gargantuan UST and JGB bond markets becoming unsustainably large in the face of rising inflation. As such, a butterfly flapping its wings in the FX markets can set off a tornado in the bond markets; it was perhaps best that the US caught said butterfly before their own yield curves went out of control.
Land of the rising yields. It was more than three years ago that we addressed this risk that was quietly bubbling in the ramen broth in our CIO Perspectives (Land of the Rising Yields: Influence on Longer-dated USD Bonds, published 27 Jan 2023). Market observers would also note that JGBs have since done exactly as the title suggested, which hopefully lends credence to the thesis at the time. Back then, unlike the rest of the world, the Bank of Japan (BOJ) was running an extremely accommodative monetary policy (negative yields). Our take was that onshore yields in Japan would continue to rise as the BOJ removes accommodation in the face of sticky inflation, causing a risk to long duration bonds across the developed market bond universe due to the permeability of capital flows. Seeing as 30Y US treasuries have since risen from c.3.62% at the time of reporting to c.5.25% today (with JGBs faring even worse), it would have benefitted fixed income portfolios to have heeded that risk.
Why Japan cannot tighten policy aggressively. As anticipated, monetary policy in Japan eventually entered a series of hikes beginning in Mar 2024 as inflation took hold. The perception over the last three years however, had been that the BOJ had been much too slow to react, lacking the “Warsh-like” conviction necessary to instil market confidence that price stability would be achieved. One cannot, however, fault the BOJ for its inertia. Lest we forget, government debt to GDP in Japan sits at an eye-watering c.236% versus c.120% for the US, implying that every 1% increase in the policy rate in Japan eventually diverts more than 2% of GDP to interest payments, leaving much less in the coffers for the Takaichi government to spend on critical reforms around defence, economic security and semiconductors; not forgetting the concurrent pursuit of bringing food consumption taxes down which further reduces fiscal revenues. As such, inflation expectations took off, largely through the steep rise in long-dated JGB yields that persists to this day.
DM with EM characteristics. Typically, developed market (DM) bond yields such as those in Japan do not rise forever; there comes a point where they should in theory be attractive enough to pique the interest of domestic investors. Moreover, the US pursued a diverging easing policy bias between 2024-2025, cutting rates under the Powell-led Fed as inflation in the US moved in the right direction. The theory of interest rate parity suggests that the forward expectations of currency pairs should be correlated with the differences in national interest rates; i.e. as US rates came down and Japan rates went up, the yen should have appreciated against the dollar. However, the USDJPY continues to defy the gravity of financial theory by weakening to levels not seen in decades.
While odd, there is another category of fixed income that often displays such characteristics: emerging market (EM) bonds during episodes of currency crises, where the currency weakens amid rising yields as investors head for the exits. Certainly, to call a technologically-advanced, industrialised nation such as Japan an “emerging market” would be sacrilegious, but we are running out of ways to explain the impotence of yield differentials in saving the yen. Viewing this through an EM lens, what would eventually “save” the currency would be confidence that Japan has sufficient international reserves to defend the yen through intervention.
Yin and Yang. Now here is where Japan looks nothing like an EM country. Being the industrial powerhouse that it is, Japan is a creditor nation with a largely positive net international investment position (NIIP) to the tune of c.81% of GDP. This means that the total value of foreign assets owned is significantly larger than the size of their domestic assets owned by foreigners; a large buffer of foreign reserves that they can tap on in a currency crunch, including more than USD1tn in US treasuries that they currently hold as America’s largest foreign creditor. The US, on the other hand, is a debtor nation, with an NIIP of c.-71%—a near mirror-image of Japan—meaning that foreigners own much more of its assets (such as US treasuries) and therefore making them prone to capital flight risk should there be signs of repatriation.
Their currency, your problem. Here we come to the crux of the matter. For years, Japan was forced to pick its poison, choosing between (a) sacrificing its currency to save its bond markets (by keeping real rates low), or (b) sacrificing its bond markets to save its currency (by raising rates aggressively). It now realises that attempting to save both JGBs and the yen risks losing both as EM characteristics come into play. There is one final lever to pull—capital repatriation—where Japan begins to attract capital back to the homeland through (a) enticement: undergoing capital market reform to make the domestic markets more attractive, or (b) regulation: raising the requirement for Japanese firms to hold more domestic securities. Capital repatriation is the only means to maintain an appreciation bias on the yen while also keeping a lid on bond yields, but it comes at the expense of foreign investments like US treasuries which must be sold. The US recognises that the Japanese currency is now their problem and has (a) expanded the Fed’s FIMA Repo facility to let Japan borrow dollars against US treasuries as collateral (instead of outright selling), and (b) jointly intervening in the USDJPY markets to strengthen the yen as if this were the Plaza Accord all over again.
What does this mean for fixed income? Given that US involvement has arrived, it appears that there are “lines in the sand” for yields that should not be crossed; namely for US 10Y yields at 4.7% and US 30Y yields at 5.25%, and the actions around bonds at these levels should be closely watched. From a trading perspective, these would mark good entry points, although one must be aware that bond yields react to much more than US-Japan relations—the fundamental forces of debt sustainability and inflation remain the bigger headwinds to watch. We reiterate that for longer term portfolios, our 5-7Y optimal duration is much preferred for a longer-term construct, with a preference for A/BBB quality credit.
Figure 1: Up, up and away goes JGB yields
Source: Bloomberg, DBS
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