Last week’s crash rattled global markets; today, the 40-year Japanese government bond auction is in the spotlight.

Turbulence in the Japanese bond market is evolving into a systemic risk for global investors, and Wednesday’s auction of 40-year government bonds in Tokyo will be a key test.

Sanae Takaichi’s proposal for more accommodative fiscal policy this month has triggered sharp fluctuations in the yen and Japanese bonds. Last week, the yield on 40-year Japanese government bonds briefly surpassed the historic high of 4%, an unimaginable level that highlights investors’ concerns over the sustainability of Japan’s debt.

The yen recently fell to nearly 160 against the dollar, amid market rumors that Japan’s Ministry of Finance may have stepped in to intervene. The yen rebounded by as much as 2% this week, but analysts warn that simple currency intervention has limited effectiveness. Goldman Sachs’ Chief FX and Emerging Market Strategist Kamakshya Trivedi noted that a more successful approach would be for the Bank of Japan to accelerate rate hikes.

The impact of this turmoil is spilling over. Japan is one of the largest foreign sovereign holders of U.S. government bonds, holding $275 billion in agency mortgage-backed securities. If Japanese government bond yields rise further, it may prompt Japanese investors to repatriate overseas funds, pushing up U.S. and European bond yields regardless of whether the Federal Reserve continues to cut rates.

Fiscal Stimulus Plan Sparks Bond Market

Since Sanae Takaichi took office last October, she has proposed cutting food sales taxes to stimulate the economy, but this plan has triggered market panic given Japan’s already heavy debt burden.

According to International Monetary Fund data, Japan’s total debt stands at 237% of GDP, the highest in the world. Since Takaichi took office, 40-year bond yields have risen by a total of 51 basis points.

Bond investors tend to be wary of policies that signal rising debt burdens, especially for governments already deep in debt. Robin J. Brooks, senior fellow at the Brookings Institution, wrote in Substack last month that the standard policy prescription for countries with excessive debt is to cut spending and raise taxes, not the opposite.

Yen Volatility Grips Global Markets

David Rosenberg, founder of Rosenberg Research, said early Tuesday that the yen is approaching a potential breaking point, having tested the 100-day trend line near 154.

He emphasized: "What happens in Japan doesn’t just stay in Japan; global bond markets and currencies are watching this tug-of-war."

The direction of the yen has a direct impact on multiple interests. A stronger yen will make U.S. goods more price-competitive in Japan and help the Trump administration reduce the trade deficit. But domestically in Japan, a stronger yen will reduce the profits of exporters like Toyota and Nintendo, and could reverse the Nikkei’s nearly 6% gain so far this year. Jefferies Chief Economist Mohit Kumar expects the yen to strengthen to below 150 against the dollar.

Wednesday Auction a Critical Test

Although prices for 40-year bonds have rebounded since last week, Wednesday’s auction will be a major test. If demand is weak, it may spark another round of selling.

In a research note on Tuesday, BTIG pointed out that Japan is currently the largest foreign sovereign holder of agency mortgage-backed securities, holding $275 billion and net buying $10 billion just last year.

Kumar warns: “Any further selloff in Japanese government bonds will prompt Japanese investors to shift their attention from U.S. and European bonds back to the domestic market.” This could push up U.S. government bond yields no matter which way Fed policy goes. This is precisely why volatility in the Japanese bond market is critical for U.S. and European investors: repatriation of funds could trigger a global chain reaction.

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