In Summary
The major sell-off on the long end of the Japanese sovereign yield curve is not a “Truss moment” but signals a bumpy final stage of Japan’s monetary normalization. Just three months into her premiership, Prime Minister Sanae Takaichi dissolved the Lower House, aiming to convert her high personal approval ratings into a firmer mandate for her governing coalition and approve a more expansive FY2026 budget bill by 31 March. Snap elections will be held on 8 February. But her campaign promise to suspend the food tax, alongside potentially higher defense spending, could send Japan’s debt-to-GDP ratio up to 228% by 2050 (vs. 189% expected under the current draft budget and 200% in 2025), sparking market fears about Japan’s debt sustainability and the potential inflationary impact of the government’s fiscal stance. The long end of JGB yield curve shifted up 20-30bps in one session. If sovereign yields remain at current forward rates, the debt-to-GDP ratio would rise to 209% by 2050 under the FY2026 draft budget scenario, or 254% under the more expansive fiscal policy scenario.
Japan being a major external creditor means domestic bond market pressures can be exported to the global financial system through the liquidity channel. Its Net International Investment Position of around +110% of GDP raises the risk of a JPY-driven deleveraging. If JGB yields remain this high and volatile, we could see a downside scenario emerge where a JPY-led deleveraging wave forces sales of US treasuries and sell-off in US equities. We see the breaking point in a sudden shift of US Treasuries to around 5%. The biggest risk remains the depressed funding conditions in Japan, which are already at levels that coincided with US equity sell-offs (-15% per month) and volatility spikes in the past.
Positioning on the JGB curve: from the “widow maker” to the Takaichi trade. For decades Japan was “Zeroland”: zero policy rate, zero bond yields, zero borrowing cost. With the BoJ controlling the entire yield curve, betting against the Japanese bond market was known as the “widow maker trade”. But the tide is turning following the normalization of monetary policy that began in 2024. We expect a terminal rate of 1.5% by end-2027; quantitative tightening should continue while FX interventions should be balance-sheet neutral. After the recent bond market sell-off, we see short-term opportunities in the context of the BoJ’s normalization and Takaishi’s likely upcoming policies: We expect some flattening at the long-end of the JGB curve, while issuance pressure shifting to the 5y to 10y segment should result in some steepening pressure on the belly. Holding Japanese bonds also becomes a carry-yielding hedge against macro volatility as they would benefit from a global risk-off and carry-trade deleveraging.
With recent central bank interventions, the JPY has also returned to the center stage of global FX markets. But this is not the only reason for USD weakness. It is rather the latest episode of an underlying USD depreciation trend reflecting a mix of rising policy uncertainty, de-dollarization, fiscal dominance fears and global deleveraging.