Japan’s economy is returning to something resembling normality for the first time in decades. That’s likely to mean more volatility ahead for the yen and other Japanese assets, as investors try to make sense of this new reality.
While Japanese equities are rising to levels never seen before, that is less remarkable because many other countries’ stock markets are also hitting new all-time peaks. The more intriguing market moves in Japan are happening in government bonds (JGBs) and the yen.
Bond yields across the JGB curve are at multi-decade or record highs, marking a stark disconnect from other major debt markets like the U.S., where Treasury yields have been fairly stable in recent months.
The yen, which was the worst-performing major currency against the dollar last year, has weakened even more to kick off 2026. On Wednesday, it fell to an 18-month low around 160 per dollar, territory that has previously prompted waves of yen-buying intervention from the Ministry of Finance.
There appears to be a disconnect here. Central bank interest rate hikes and rising bond yields should support the currency, right?
That logic doesn’t always hold, however, especially when Japan’s unique debt dynamics and inflation history are taken into consideration.
Japan has amassed the world’s largest public debt pile of more than 230 per cent of GDP, thanks to decades of “quantitative easing” bond-buying, borrowing, fiscal largesse, and near-zero interest rates to try to pull the economy out of a prolonged deflationary funk.
It appears to have won that battle. Annual inflation is running at around 3 per cent, exceeding the Bank of Japan’s 2-per-cent target every month for nearly five straight years. And wage growth has been robust in recent years, even if it is now slowing.
The Bank of Japan (BOJ) is finally increasing borrowing costs, albeit cautiously. It lifted its policy rate last month to a 30-year high of 0.75 per cent from 0.5 per cent. This is the slowest policy tightening cycle in modern history, with rates increasing just 85 basis points over two years, but it still is confirmation that deflation-haunted Japan may no longer be such an outlier.
As independent economics commentator Matthew Klein observes: “Far from indicating trouble, Japanese bond prices are implying that Japan has converged, in at least one important way, with the rest of the rich world.”
That may be true, but for many Japanese businesses, consumers, and investors, the highest interest rates in 30 years represent a step into the unknown. With this comes uncertainty, and therefore a likely increase in expected volatility.
This helps explain why the recent rise in JGB yields has triggered such an adverse reaction in the yen. Investors appear to fear that historically high borrowing costs could precipitate a fiscal crisis that will only tighten the squeeze on JGBs and the yen.
Yen volatility has already been creeping up in the last few years. Since late 2022, implied three-month dollar/yen volatility has been consistently and often significantly higher than comparable measures in euro/dollar and sterling/dollar.
It wasn’t always thus. For long spells over the past quarter century, yen “vol” was in line with, or lower than, its euro and sterling counterparts.
But times have changed, and there are plenty of reasons to expect yen “vol” to stay elevated.
Although “real” inflation-adjusted Japanese rates and yields are still negative, nominal rates are rising, and they could climb further on the back of Prime Minister Sanae Takaichi’s plans to prime the pumps. The gap with borrowing costs in the U.S. and other developed markets is narrowing, which may spur a yen rebound, especially if it is backed by intervention from Tokyo.
Japanese authorities have conducted four bouts of yen-buying in recent years: twice in 2022 and another two times in 2024. Traders are on high alert for a fifth.
For the first time in decades, Japan has got inflation, wage growth, and rising borrowing costs. It’s a new “normal” that will take some getting used to.