When and why will Japanese government bonds and the yen reach a turning point?

UBS’s latest global strategy report notes that the recent sharp rise in Japanese government bond (JGB) yields has significantly exceeded what can be explained by fiscal fundamentals, with the core driver being the market’s repricing of inflation expectations. The bank believes that current inflation will fall back to around 1.5% by mid-year, which will be a key turning point for Japanese bonds and the yen.

According to Chasing Wind Trading Desk, the report outlines three key signals for investors: first, this bout of volatility is not a systemic risk event like the UK’s 2022 “Truss Crisis,” and the Japanese stock market remains resilient, especially, panic selling of rate-sensitive sectors should be avoided; second, as Japanese bond yields become more attractive, domestic Japanese funds are expected to flow back from overseas bond markets on a large scale after the new fiscal year begins in April, reallocating into Japanese government bonds; finally, cooling inflation will drive real interest rates higher, which will support the yen, and real interest rates have a more significant impact on exchange rates than nominal spreads.

Fiscal fundamentals are not to blame, yield rises have been “excessive”

Although there are market concerns about Japan’s fiscal situation, recent data shows that the wild swings in Japanese government bond yields are markedly disconnected from actual fiscal fundamentals.

Looking at fiscal health, Japan is better off than most developed economies. Since 2023, its public debt-to-GDP ratio has fallen by 11 percentage points, while developed economies as a whole have risen by 2 percentage points in the same period. It is forecast that by 2026, Japan’s fiscal deficit will be only around 2% of GDP, much lower than the average 4.9% for developed economies. In addition, Japan’s government interest payments are 1.3% of GDP, far below the developed economies’ average of 3.3%.

However, despite Japan’s relatively sound fiscal metrics, the rise in JGB yields has recently outpaced all major developed bond markets. The core reason for this “disconnect” is changes in market structure and liquidity: the trading volume that triggered sharp market swings on January 20 was only $280 million, reflecting inadequate market depth; meanwhile, the Bank of Japan has continued to reduce its bond holdings, resulting in a disordered price discovery mechanism in the absence of a key market maker, amplifying short-term volatility.

Inflation expectations are the core driver, but cooling is near

UBS analysis points out that the recent surge in Japanese bond yields is mainly driven by market inflation expectations, not fiscal deficit pressure. Current Japanese inflation is primarily pushed by structural factors such as food prices (e.g., rice) while underlying services inflation remains moderate at about 1%.

Looking ahead, the bank expects Japan’s core inflation rate to fall back to around 1.5% by mid-year. Referencing European experience, as supply shocks (such as energy and food price volatility) gradually fade, overall inflation will decline, which in turn will lower inflation expectations and wage growth rates simultaneously.

All factors considered, if inflation eases as expected, its effect will more effectively increase real yields than the Bank of Japan’s rate hikes, providing key support for Japanese bonds and the yen.

Yen pricing logic changes: real interest rates over nominal spreads

Recently, the traditional relationship between the yen and US-Japan nominal interest rate spreads has broken down, with real rate differentials becoming the core anchor for pricing. Models show that based on 2-year, 5-year, and 10-year nominal spreads, USD/JPY should theoretically be around 118; however, using real rate differentials, the value is about 155, which aligns closely with actual market exchange rates.

This difference reflects the market’s close attention to Japanese inflation trends and their potential threat to monetary policy independence. If inflation falls back as expected, real interest rates will rise accordingly, providing key support for the yen.

From a policy response perspective, UBS analysis notes that unilateral FX intervention is usually short-lived. In contrast, if the US and Japan coordinate action and implement joint intervention (similar to the model in June 1998), it could more effectively stabilize the FX market.

This is not the UK “Truss moment”, Japan’s external position remains sound

In response to concerns that Japan could repeat the UK’s 2022 gilt crisis, UBS notes there are significant differences between the two in fundamental factors and market reactions:

Japan holds massive net international investment assets, amounting to +92% of GDP, compared to -2.6% for the UK during its crisis; meanwhile, Japan’s current account is in surplus at 4.8% of GDP, while the UK’s was in deficit. The sound structure of external assets and liabilities provides Japan with considerable buffer.

In terms of market performance, the UK crisis saw both stocks and bonds fall, while in Japan, rate-sensitive sectors such as real estate and construction are outperforming the broader market, suggesting no systemic doubts about Japanese sovereign credit.

The real risk: Japanese capital repatriation and “hot outside, cold inside” in the stock market

The main spillover risk facing global bond markets does not come from foreign investors selling Japanese bonds, but is more likely to arise from a large-scale repatriation of Japanese domestic capital from overseas bond markets. UBS points out that as Japanese government bond yields now exceed global bond yields after currency hedging, Japanese institutional investors may significantly shift allocations in the new fiscal year (starting April 1), moving funds from overseas bonds into domestic government bonds.

On the stock market, Japan shows clear structural differentiation. Since 2025, just three stocks have accounted for about 55% of the Nikkei 225’s gains, highlighting market concentration. At the same time, the current rally has been driven entirely by foreign investors and corporate buybacks, with domestic individuals and institutions still net sellers. This “hot outside, cold inside” capital pattern also indirectly reflects local investors’ cautious view on the persistence of inflation.

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The above outstanding content is from Chasing Wind Trading Desk.

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