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Japan’s Bond Market Shock: What Rising Yields Portend for International Investors

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Japan Bond Yield Spike Sparks Global Carry Trade Fears
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Japan’s bond market has been in the spotlight after a huge warning sign was witnessed last week. The auction for the government’s 40-year bond witnessed surprisingly soft demand as investors avoided lending to the country for such a duration. As a result, Japan bond yields went to an all-time high, scaring financial experts all over the world.

The sale of ¥500 billion ($3.46 billion) of 40-year state bonds saw a record-low bid-to-cover ratio of 2.21, the lowest since July 2024. Yields hit a record 3.675%, indicating that investors are increasingly worried about Japan’s long-term financial health.

Why This Matters: Japan’s Growing Debt Burden

Japan has the highest debt-to-GDP ratio among developed nations, at around 248%, double that of America. Such mammoth public debt has been a problem forever, but with ultra-low interest rates until recently, it could be managed.

And now, as interest rates are slowly rising and inflation is sneaking back into the global economy, investors are beginning to demand returns to be higher as compensation for the perceived risk. That has been pushing longer-term bond yields higher and casting fresh doubts on Japan’s future economy.

The Yen Carry Trade Under Pressure

A major worry is the potential to reverse the yen carry trade. Investors have for decades borrowed yen at exceptionally low rates and placed the money in higher-yielding assets in other nations. This has created a global pool of funds that supports many financial markets, especially in Europe and America.

Nevertheless, Japan’s central bank, the Bank of Japan (BoJ), is presently gradually turning away from its ultra-loose approach. It already ended negative interest rates and its Yield Curve Control policy while raising its benchmark rate to 0.25%. With higher rates, borrowing in yen becomes less attractive, and the entire carry trade strategy is under reconsideration.

What’s Happening Globally?

The change in Japanese monetary policy is having a ripple effect worldwide. In August 2024, fear of increasing Japanese interest rates pushed world markets into panic selling mode. The Nikkei 225 fell in its worst fall since 1987, and the yen sharply rose as foreigners rolled over their positions.

If other investors begin to unwind their carry trades and send funds back to Japan, it would lead to lower liquidity in global markets. This would increase the price of borrowing and lead to increased market volatility around the world.

Japan’s Next Steps

In an attempt to reverse the weak demand for bonds, Japan’s Ministry of Finance is reported to be mulling changing the way it sells government bonds. Instead of offering mostly long-term debt, the government may shift towards issuing more short-term bonds, which are easier to sell and less risky.

However, the market remains to be risk-averse. Now, pressure rests upon Japan to walk a tightrope in balancing its fiscal policy wisely without shocking its own economy as well as the overall global financial system.

This is more than a local issue. Japan’s bond market has been the backbone of stability in the global financial system for years. But with yields increasing and investor appetite dipping, the risk of an unwind in the carry trade is genuine—and could ripple far beyond Japan.

Meanwhile, investors and policymakers around the world will be paying close attention to how Japan navigates this fork in the road.

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