What has happened in the Japanese market recently?
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The Japanese market is undergoing a significant turning point, with a fundamental shift in market pricing logic. After the Liberal Democratic Party won a landslide victory in the House of Representatives election, the yen yield curve flattened, inflation expectations stabilized, and the yen strengthened—showing the typical response of developed markets to expectations of higher real interest rates.
On February 14th, according to Wind Trading Desk, Goldman Sachs pointed out in its latest report that the market is beginning to price in the possibility of Japan exiting the ultra-low real interest rate regime, rather than simply treating it as an inflation shock. The core driver of this change lies in the fact that investors are assigning a higher probability weight to asset repatriation expectations and exiting the ultra-low real interest rate regime.
However, there is significant uncertainty as to whether this shift can be sustained. Goldman Sachs warns that if the Bank of Japan fails to deliver on the market’s expectations for a more hawkish path, previous market dynamics may return, leading to a weaker yen and increased volatility at the long end of the yield curve.
The report specifically points out that the key risks are concentrated on the Bank of Japan’s policy path. If the Bank of Japan shows any dovish signs in accelerating rate hikes—especially considering the yen’s recent strength—it will likely catalyze the return of pre-election trading dynamics.
Fundamental Shift in Market Pricing Logic
According to the report, two weeks ago, Goldman Sachs’ analyst team proposed a framework to understand the performance of Japanese government bonds and the yen under the current policy mix. The logic at the time was that with policy rates constrained, rising inflation, and planned fiscal expansion, simultaneous weakness in both bonds and currency was a reasonable market response.
Goldman Sachs points out that after the election, the market has shown markedly different dynamics: real rates have risen slightly, forward inflation expectations have edged lower. Stock prices are up, accompanied by a flatter nominal yield curve and a stronger yen.
The firm believes that this cross-asset response is clear and consistent, matching the typical correlation patterns observed in developed markets when real inflation approaches target levels.
Data shows that the movement of 2-year and 3-year forward real swap rates and inflation swap rates has clearly diverged since the second half of 2025, with real rates rising steadily and inflation expectations stabilizing.
Asset Repatriation Expectations Become Core Driver
Goldman Sachs believes the key to the change in market pricing logic is that investors have begun to assign higher probability weights to portfolio movement and the exit from ultra-low real rate regimes.Combined with expectations for new fiscal measures, these market moves mainly reflect pricing in the increased likelihood of asset repatriation given Japan’s net international investment position.
The report says some investors interpreted recent statements by the Finance Minister as signals supporting foreign asset repatriation.
Given Japan’s strong net international investment position, using overseas assets to fund new fiscal expansion, or shifts in private sector portfolio flows and FX hedging, could stabilize the yen and lift prices of other domestic assets.
It is worth noting that recent market moves have significantly narrowed the gap with Goldman Sachs’ model predictions. The actual level of 10–30 year Japanese government bond spreads is close to the model’s fitted value, suggesting the market is indeed pricing in a different regime post-election.
The Bank of Japan’s Policy Path Faces a Test
Whether current market dynamics can persist largely depends on whether Japan can truly exit the ultra-low real rate regime. Goldman Sachs points out that institutional challenges and policy debates in Japan may make this shift difficult or much slower.
Goldman Sachs believes that if the recent strength of the yen continues, the Bank of Japan will likely remain calm, which may reignite pre-election dynamics—i.e., a weaker yen as a key premise for faster rate hikes.
Given the current pricing of the policy path and market exploration of the possibility of exiting the low real interest rate regime, if the Bank of Japan shows any dovish signs in accelerating rate hikes, it will likely catalyze the return of pre-election trading patterns.
In terms of policy trajectory, only the March meeting currently provides a convincing risk-reward ratio, pricing in 7 basis points.
According to the report, even if risks of a weaker yen and a steeper long-end curve reemerge, this doesn’t constitute Japan’s inflation equilibrium. Goldman Sachs believes that unless the inflation outlook declines, volatility in mid-curve rates (around the 5-year segment) is unlikely to decrease.
Data shows a clear correlation between the 5–30 year swap spread and volatility spread. As the 5–30 year swap spread rose from about 0.8% at the start of 2024 to current levels, the implied volatility spread between the 30-year and 5-year also widened significantly.
Goldman Sachs believes that this volatility pattern suggests that the risk of a sustained flattening of the yen yield curve is higher over the long term.
The report notes that in the short term, during the information vacuum over the next few weeks, current market conditions may continue. But Goldman Sachs leans toward the view that this change “may have come too fast, too much.” If the Bank of Japan uses the opportunity of recent yen strength to maintain a more gradual rate hike trajectory, a weaker yen and rising long-end rate volatility may follow.
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