AI bubble o’clock, Japan’s spendy stimulus and EM central banks hit a fork in the road

The financial market frenzy over AI shows classic signs of an asset bubble: widespread consensus, unproven valuations and returns at times detached from earnings. While economics cannot time a bursting bubble, the “Minsky Clock” suggests we are in a late-cycle phase. Our AI Bubble Risk Monitor, which looks at 30+ indicators across market signals, earnings expectations, financial risks and fundamental risks, suggests rising but still manageable bubble pressures. Market signals are mixed, though narrowing equity-market breadth and compressed technology credit spreads stand out, reflecting heavy debt-funded expansion by hyperscalers. But exuberant expectations show the strongest overheating, with persistent earnings upgrades and high forecast dispersion. Financial risks are elevated as corporate debt issuance climbs to fund large-scale AI capex, while fundamental indicators point to shorter GPU product cycles and tightening energy constraints as key indicators to monitor. Ultimately, while the long-term adoption of AI should outlast market corrections, the real risk is the markets may have priced in decades of growth overnight, leaving valuations vulnerable if adoption proves slower than expected.

The FY2025 supplementary budget, for which the Cabinet finalized the funding plan today, amounts to JPY21.3trn (3.3% of GDP), with a large rise in direct spending. This should worsen the fiscal deficit but will not prevent public debt-to-GDP from declining. We revise on the upside our GDP growth forecasts to +1.4% in 2026 (+1pp) and +1% in 2027 (+0.2pp) – less ambitious than the government – to account for uncertainties and potential tightening of financial conditions. Headline inflation is likely to fall below the BoJ's 2% target by early 2026 but core inflation should remain high. As a result, we keep our outlook for the next BoJ hike in January, with the policy rate ending 2026 at 1.0% and 2027 at 1.5%. We do not think the immediate market reaction was a "Truss moment", but rather a repricing of Japan’s policy mix (fiscal expansion and monetary tightening). Of the 1.8% 10-year JGB yield, 1.3% is now explained by the term premium, of which 0.7% is related to fiscal risks and 0.6% to inflation risks. We see a risk that markets may start testing the BoJ’s commitment to monetary tightening, potentially forcing more aggressive interventions such as FX operations (with a likely trigger near 165 USD/JPY), an aggressive hawkish shift or resuming bond purchases to cap yields. Ultimately, the longstanding paradigm of the JPY as a low-yielding, stable funding currency is eroding and the role of the JGB market as a provider of global liquidity will diminish, leaving global financial markets more fragile.