Japan's financial markets are experiencing a long-awaited "reflation trade," with the notable absence being Japanese domestic investors. Led by foreign investors, Japanese stocks hit record highs last month, while the yen also appreciated. Foreign investors have also been significant buyers of Japanese government bonds, pushing 30-year JGB yields to historic peaks. Data shows the Topix index has risen 34.2% since touching lows in April.

"Global investors are a key driver behind the Japanese stock market rally," said Nicholas Smith, a Tokyo-based strategist at CLSA. He added: "We see virtually no domestic Japanese investors chasing the rally."

As government supportive policies and corporate reforms help Japan reignite economic growth after nearly three decades of stagnation, the Bank of Japan conducted its first rate hike since before the 2008 global financial crisis this year and reduced its massive JGB holdings. This move has driven asset rotation between bonds and stocks, causing traditional industrial stocks to surge significantly while high-growth stocks underperformed. Meanwhile, in the JGB market, investors prefer short-term bonds over long-term ones.

Some analysts believe this rally could have more room to run if Japanese retail investors return to the stock market after withdrawing approximately $23 billion this year. Bernstein analysts noted in a research report: "Retail sentiment has finally turned positive again since last week, after being extremely pessimistic."

Strategists believe retail investor caution stems from uncertainty about how US tariffs might affect Japan's economy and market volatility. However, they added that the combination of earnings recovery, strong foreign investor confidence, and retail fund repatriation "is very favorable for the market."

Foreign capital inflows into Japanese stocks this year have been the strongest in a decade, potentially reaching the highest levels since "Abenomics" triggered inflows in 2013. Nicholas Smith added: "It's not just foreigners buying; corporate buybacks are even larger in scale."

"This is very encouraging because companies have ample cash and are fully capable of conducting more buybacks."

Despite significant volatility in stock and bond markets, the yen has remained relatively stable. Over the past two years, the USD/JPY exchange rate has "stubbornly" maintained a range of 140-160, failing to strengthen despite improved growth prospects and investors pouring funds into Japan for higher bond yields or equity returns.

"The key issue is the lack of repatriated funds," said Brad Setser, senior fellow at the Council on Foreign Relations. He noted this lack is primarily because Japanese institutional portfolios invested heavily in US Treasuries before the pandemic, but these investments became essentially "trapped" after the Federal Reserve raised rates.

In essence, Japanese capital remains overseas rather than returning home to chase yields. Analysts and traders are closely watching whether this trend will change as Japan's financial markets fully activate.

Here are some charts illustrating Japan's asset rotation:

1. Asset Class Rotation Investors betting on stronger economic growth are withdrawing from fixed-income assets and moving into equities. The Nikkei 225 and Topix indices have both hit record highs this year.

2. Value Stocks Outperform Growth Stocks Similar to reflation trades in other countries, Japanese value stocks have outperformed growth stocks. Quantitative investors typically interpret this trend as growth momentum spreading more broadly throughout the economy.

3. Carry Trade Foreign buyers can achieve significant excess returns in Japanese government bonds. Five-year US Treasury yields are only 3.86%, while similar-maturity JGBs can provide 5% returns when hedged back to USD. This bond market "magic" is possible due to the massive interest rate differential between the Federal Reserve and the Bank of Japan.

4. Yen Hedging Costs The above carry trade is only effective for foreign investors. Due to the Bank of Japan's relatively low interest rates, Japanese investors face higher costs for currency-hedged investments in the US.

5. Japan's Overseas Wealth Earlier this year, Japan lost its title as the "world's largest creditor nation" to Germany. However, Japan still has considerable financial assets overseas that could potentially be sold and repatriated when necessary.