French debt was the first victim, followed by US debt? Has the world felt the effects of Japan's interest rate hike?

The sell-off in French bonds intensified, with the yield on 10-year French government bonds approaching 5%, the highest since 2002, and borrowing costs now exceeding those of Greece and Italy. Meanwhile, US Treasury yields climbed to a multi-decade high of 5.28%, with even softening inflation data failing to halt the sell-off.

Both storms may have Japan's shadow behind them. Bloomberg columnist Gearoid Reidy analyzed this in an article on October 9th:

Two years ago, when Japan embarked on the path of policy normalization, the question was whether Japan was ready for a "world with interest rates." Perhaps we should have asked: Is the world ready for a "Japan with interest rates"?

He believes that France may only be the first victim.

Data shows that as of July, Japanese investors held approximately 23 trillion yen ($145 billion) in French government bonds, making them the largest overweight position in the Eurozone. However, the yield on 10-year Japanese government bonds rose above 3% last month, reaching a 30-year high. After currency hedging, the yield advantage of 10-year French government bonds relative to Japanese government bonds has narrowed to only about 40 basis points.

With the loss of profitability and the deterioration of French finances, Japanese funds began to loosen.

Japanese holdings of French bonds decreased by 2.5% compared to the end of last year. Funds managed by the global fixed-income team at Sumitomo Mitsui DS Asset Management, led by Shinji Kunibe, have liquidated their French bond holdings due to fiscal concerns. Masayuki Nakajima of Mizuho stated, "Even though valuations appear cheaper, Japanese investors' incentive to rebuild positions is declining."

US Debt: How Long Can Political Asylum Last?

Reidy's analysis then turned its attention to the United States.

In the first half of this year, Japanese investors net sold 4.45 trillion yen (about US$28 billion) of long-term U.S. Treasury bonds, marking the first time since 2022 that they have seen net selling in the first half of the year.

Reidy acknowledged that a large-scale sell-off of US Treasury bonds by Japan is unlikely—Tokyo's dependence on Washington for security guarantees is a political reality. However, he pointed out that Japan doesn't need to "sell off" to raise US borrowing costs; "buying less is enough."

At the same time, Wall Street disagrees on the specific mechanisms by which Japan influences US Treasury bonds.

Ed Yardeni, president and chief investment strategist at Yardeni Research, believes the unwinding of yen carry trades is the driving force. He points out that as the Bank of Japan raises interest rates, carry traders are forced to sell government bonds they previously purchased with cheap yen loans. "This trade allowed many governments to maintain fiscal deficits without pushing up bond yields, and now it's time to pay the price," he says, characterizing the current situation as revenge by the "bond vigilantes."

Shoki Omori, chief Japan fixed income strategist at Deutsche Bank, has raised questions about this. He believes that arbitrage unwinding leaves a fixed market "fingerprint": a jump in the yen, a fall in the stock market, and a rise in US Treasuries due to safe-haven demand.

However, the current trend presents the exact opposite characteristics... Bonds and the yen are falling in tandem, which is a signal of inflation and interest rate repricing, rather than deleveraging.

The two sides have obvious differences, but they agree on one point: the root cause lies in the Japanese bond market.

Japanese funds are "going home".

Reidy's core assessment is that Japanese capital is not withdrawing from the world, but rather becoming more selective.

According to estimates by Dai-ichi Life Research Institute, the Government Pension Investment Fund of Japan (GPIF) purchased ¥5.7 trillion in Japanese government bonds in the second quarter, more than double the average level for the same period over the past five years. Public pension funds as a whole purchased ¥6.8 trillion, and banks and insurance companies have also been net buyers of Japanese government bonds in recent months.

A similar shift is occurring at the retail level. Japanese retail bond subscriptions are expected to surpass 1 trillion yen for the first time in July 2026, and remain at that level for several months thereafter—the first time this has happened since the current sales model was launched in 2014.

Reidy wrote:

Japan is rebuilding its domestic fixed-income culture, which had almost disappeared during decades of zero or negative interest rates.

It's worth noting that Japanese investors haven't completely withdrawn from overseas markets. According to Bloomberg, they remained net buyers of German, Italian, and British government bonds in the first half of this year, and demand for overseas stocks remained strong. Reidy's assessment is that Japanese capital has become more selective, rather than experiencing a comprehensive retreat.

France's own problems

Of course, the withdrawal of Japanese funds was just the trigger; the root cause was France's own financial difficulties.

The spread between French and German 10-year government bond yields widened by 32 basis points to 141 basis points last week. According to Bloomberg, Jim Reid of Deutsche Bank said this was the largest weekly widening since Bloomberg began collecting data in 1990, covering German reunification, the European debt crisis, and the COVID-19 pandemic.

French central bank governor Emmanuel Moulin warned that France could be "gradually strangled" by rising interest rates if it does not reform its public finances.

France's debt is approaching 120% of GDP, and its deficit has exceeded 5% for three consecutive years. Kevin Thozet, a portfolio advisor at French asset management firm Carmignac, said:

For years, even decades, France has been a free rider in Europe. This worked as long as nobody noticed. Now people are starting to notice.

Supply-side pressures are equally severe. The French government bond management agency (AFT) plans to issue a record €340 billion in bonds in 2027. Goldman Sachs predicts that France's net duration supply in 2027 will be about 25% higher than this year, tying with Germany for the largest increase in the Eurozone.

Antonio Del Favero of Macro Hive worries about the ripple effect: "If Japan is seen as a target for reducing its overweight position because France is no longer a 'clean core holding,' benchmark investors in the U.S., Asia, and parts of Europe may also reassess."

Hideo Shimomura of Fivestar Asset Management is more direct:

This is just the beginning. Based on the experience of the European debt crisis, if the European Central Bank leaves the issue unchecked, the yield on French 10-year government bonds could rise to 7%.

Japan itself: It has a buffer, but it is not invincible.

Reidy also pointed out that Japan is not immune to this new landscape.

However, Japan has several buffers: a relatively stable political situation, ample funds in its pension system, and, more importantly, time. As of the end of March this year, the average coupon rate on Japanese government debt was slightly below 1%, with an average maturity of nearly 10 years, meaning that the impact of rising interest rates on public finances will be gradual.

However, Prime Minister Sanae Takaichi has expressed dissatisfaction with the recent interest rate hikes and plans to replace several Bank of Japan board members with more dovish candidates. Reidy noted that her wording in her opening speech to parliament this week was noticeably more cautious, emphasizing reassurance to the markets.

Reidy's conclusion is:

Japanese capital has not withdrawn from the world. But after decades of taking it for granted, the world now has to compete with Japan's domestic market for this capital.

He concluded with a metaphor: "Discerning Japanese consumers have long been willing to pay a premium for luxury goods such as French handbags. Now, French bonds—and everyone else's bonds—must in turn provide them with a premium."

Risk Warning and DisclaimerInvesting involves risk; please exercise caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Any investment decisions made based on this information are at your own risk.