While Japan has a longstanding reputation for having the world’s most boring bond market - with interest rates stuck at zero for decades – recent developments have witnessed more pathos in the country’s bond market than Madame Butterfly on steroids.
First, some of the more recent histrionics.
Over the last week, Japanese bond yields spiked after prime minister Taikachi suspend the consumption tax for food for two years and called a snap election for 8 February.
The market’s response was swift and sharp, with the yield on 30-year Japanese Government bonds (JGBs) spiking up to 3.89%, while the 40-year bond yield hit 4% - both their highest since issuance of these tenures began.
Given the stability of Japan’s bond market, a 20-plus basis-point one-day move caused panic, with some market commentators drawing parallels with former UK prime minister Liz Truss’s fated mini-budget in 2022.
Storm in a Japanese tea cup?
What followed next were revelations by Bloomberg chief correspondent Ruth Carson that Japan’s yield spike was triggered by a paltry $280 million of trading – which is tantamount to one regular-sized bond market trade.
Confused? Let’s drill down into what’s really going on.
Japan’s finances aren’t in great shape, with net debt sitting at a relatively high 134% of GDP in 2025 (gross debt is higher at over 230%), and Japan’s budget remains in deficit.
However, Japan’s debt isn’t really in serious trouble [like the U.S.], with debt as a percentage of GDP having declined over the past five years.
Unlike the UK or the U.S., Japan has a current account surplus – meaning that it’s a creditor to the rest of the world - with government borrowings being offset by savings from the rest of the country.
However, lurking beneath the surface are some concerning developments, both for Japan’s bond market and bond markets at large.
Major liquidity problems
According to Janu Chan economist Bite-Sized Economics, what’s underpinning a clear structural shift in Japan’s economy is the emergence of inflation, which has been sitting at 2% or higher for nearly four years now.
Price increases have also shifted wage-setting behaviour, and with some moderate inflation in place, Chan expects that process to continue.
Chan also attributes major liquidity problems in Japan’s bond market to the legacy of the Bank of Japan’s (BOJ) former bond purchases.
Underpinning the issue were BOJ’s yield curve control (YCC) measures introduced in 2016, capping the 10-year JGB yield at 0%, with later adjustments.
Unsurprisingly, when global inflation surged during the pandemic and bond yields rose, markets expected rates worldwide to lift from zero.
However, to maintain the cap, the BOJ had to buy ever larger quantities of Japanese Government Bonds (JGBs), eventually owning 100% of a specific 10 year issue and about 50% of the entire JGB market.
Japanese government bonds left impaired
Speculation intensified that YCC would have to be abandoned, especially after the Reserve Bank of Australia (RBA) dropped its own YCC in November 2021 following a failed attempt to contain rising yields.
Japan appeared to have exited its YCC measures in 2024 with minimal disruption; however, Chan reminds investors that its massive and prolonged bond purchases left the JGB market severely impaired.
“Liquidity dried up, the market effectively disappeared for long stretches, and even post-YCC, the BOJ still holds a dominant share,” said Chan.
“This matters because a wide range of interest rate products and derivatives rely on a functioning JGB market for pricing.”
What’s become glaringly obvious in light of recent developments is that Japan’s [bond-related] chickens are finally coming home to roost.
Has Takaichi backed herself into a corner?
Fast forward to 29 January 2026, and the main problem confronting Takaichi is that she’s proposing a sizeable tax cut, with no means of raising funds elsewhere.
“Takaichi’s timing is especially poor. She wants to implement Abenomics-like policies when Japan isn’t stuck in a deflationary trap anymore,” Chan notes.
“It is also at a time when bond investors have been more alert regarding the debt sustainability of governments. Inflationary environments aren’t the best time to ramp up fiscal spending.”
Meanwhile, the fallout, adds Chan, is less about Japan’s debt levels getting out of control, and has more to do with inflation repricing the risk of that debt.
In short, BOJ’s large-scale bond purchases in earlier years is now hindering the smooth functioning of the JGB market, which has led to volatility in other assets and markets.
“In a nutshell, it would seem like the root issue is more of a liquidity issue rather than a solvency issue, but that doesn’t mean that there’s no concern about debt sustainability,” she said.
What happens next?
The U.S. Treasury and Japan’s Ministry of Finance appear to be treating this situation like it’s just a liquidity issue that can be addressed with FX intervention to prevent the yen from weakening further.
However, Chan warns that FX intervention is only a temporary stopgap for liquidity issues.
She questions the long-lasting effect of FX intervention if Takaichi continues with an unfunded tax cut, and over the medium term, inflation remains elevated or accelerates.
“Takaichi will need to find a way to fund the consumption tax cut elsewhere or risk the bond market would be at risk of being pummelled again,” she said.
“Expect more volatility in the lead up to the February 8 election, and there’s a high risk that the BOJ will step in to purchase bonds again, at least temporarily.”
Beyond Japan
Meanwhile, rising Japanese bond yields have triggered global market volatility and raised concerns over carry trade reversals and higher borrowing costs.
If you're new to bonds, carry trades borrow money in a low-interest-rate currency (like the Japanese Yen historically) and use it to invest in a higher-interest-rate currency.
Ironically, at the best of times, Japanese bond yields typically attract little attention from global investors.
However, with rising yields igniting concerns about the unwinding of the global carry trade and its spillover effects on global financial markets, Japan’s bond market is again on investors’ radar.
For years, investors borrowed cheaply in Japan and invested in higher-yielding assets abroad, particularly in fixed income markets in Australia, the U.S. and Europe.
Carry trades unravelling
But this strategy has begun to face scrutiny with the BOJ lifting interest rates and tightening funding conditions for carry trade participants.
In light of the announced Japanese election and a proposed temporary cut to food consumption taxes, Shane Oliver, chief economist at AMP, believes investors have every right to raise fiscal sustainability questions.
Underscoring investor fear, adds Oliver, is the flow of capital back into Japan as Japanese yields rise, reversing the carry trade and pushing up global bond yields.
“Investors then started to worry… Japan’s got this massive level of debt, massive budget deficit,” noted Oliver.
“Then that saw long-term bond yields rise in Japan, and then a flow-on effect to bond yields around the world.”
While the direct impact on Australian households is limited, Oliver warns of potential indirect effects on borrowing costs.
“If you’ve got a higher structure for bond yields globally, and you’re wanting to take [it] at a fixed year loan, fixed, say, five-year loan, you might end up paying more for it,” he said, citing banks’ reliance on bond markets for longer-term funding.
Corporate borrowers could also face higher funding costs if global yields rise further.
However, Oliver reminded the market that variable-rate borrowers are less exposed, as most Australian mortgages are not fixed.