Why Japan matters for U.S. bond investors

A Japanese investor can now earn about 3% on a 10-year Japanese government bond versus 2% on a 10-year Treasury after hedging back into yen using rolling three-month FX forwards. See the chart. Japan now offers a meaningful risk-free yield: the 10-year JGB yield is up roughly 90 basis points this year and briefly topped 3%, while the 30-year has hit a record 4.18%. The economic backdrop warrants tighter policy as underlying inflation persists and wages rise. Yet more expansionary fiscal policy and government debt of more than twice GDP make higher rates costly. Keeping policy too loose has weighed on the yen, which fell to ¥160 per dollar last week before rallying on speculation of further intervention. Moving faster adds to fiscal pressure. With markets fully pricing a BoJ hike this month, that tension puts fiscal-dominance risk increasingly in focus.

A faster BoJ hiking cycle would reverberate well beyond Japan. Decades of ultra-low domestic yields pushed Japanese investors overseas for income, making the country a major exporter of capital. That calculation is changing. Japan still holds roughly $1.1 trillion of U.S. Treasuries. For scale, an illustrative 5% shift would amount to $55 billion – equivalent to roughly a quarter of the increase in total foreign Treasury holdings over the past year and about 7% of the Treasury’s expected net borrowing this quarter. That would be meaningful at the margin even without a large-scale repatriation wave. This matters as governments and companies compete more intensely for a finite pool of capital.

The spillover risks are real. A weaker yen can add upward pressure to U.S. yields if Japanese authorities decide to sell foreign assets, including Treasuries, to support the currency. That helps explain why the U.S. joined last month’s yen-buying intervention – the first coordinated operation with Japan since 1998. Yet the yen weakened back through ¥160 per dollar last week before rallying on speculation of further intervention and faster BoJ tightening. The risk is a feedback loop across bond markets: higher U.S. rates could weaken the yen and pressure the BoJ to move faster, while higher Japanese rates could draw more capital home, weakening demand for Treasuries and pushing U.S. borrowing costs higher.

Japan has been one of our highest-conviction regional equity calls for years, and we still prefer its equities to its government bonds as the country shifts to a higher-inflation, higher-rate environment. We remain underweight JGBs as rising yields add to global competition for capital. We are neutral on Japanese equities after closing our overweight earlier this year as we dialed down risk amid the Middle East conflict and took profits after strong performance. Yet we still see opportunities beneath the index. For example, a steeper yield curve can boost profit margins for Japanese financials, while corporate reform, rising capital spending and the AI buildout support selected companies. More broadly, higher rates are not uniformly bearish for risk assets: we favor companies with the earnings and cash flows to outrun a higher cost of capital.

Japan’s rate reset matters beyond its borders: shifting capital flows could add to upward pressure on global yields, while higher rates increase dispersion across risk assets, reinforcing the case for selectivity.

The global bond sell-off that has defined the summer gathered fresh momentum last week, pushing yields to multi-year highs across the U.S., Europe and Japan. We see further upward pressure from higher oil prices and rate-hike expectations, alongside persistent inflation, heavy government borrowing and rising corporate financing needs. Higher yields need not diminish the appeal of bonds: they have transformed the opportunity set for income, provided investors stay selective about the risks they take to earn it.

U.S. inflation takes center stage after a blowout jobs report last week strengthened expectations for a Fed rate increase this month. We still don’t see a hike as a foregone conclusion. This week’s CPI report will provide another crucial piece of data, with a hot print likely to tip the balance toward a hike and push global yields higher.