UBS's latest global strategy report indicates that the recent sharp surge in Japanese Government Bond (JGB) yields has significantly exceeded the range explainable by fiscal fundamentals, with the core driver stemming from the market's repricing of inflation expectations. The bank believes current inflation will retreat to around 1.5% by mid-year, which will become a critical turning point for the trends of JGBs and the yen.
According to the report, this conveys three key signals for investors. First, this volatility is not a systemic risk event akin to the UK's 2022 "Truss crisis"; Japanese stock market performance remains resilient, and investors should particularly avoid panic selling interest-rate-sensitive sectors. Second, as JGB yields become more attractive, it is anticipated that with the start of the new fiscal year in April, domestic Japanese funds may see large-scale repatriation from overseas bond markets, leading to a reallocation into JGBs. Finally, a decline in inflation will push real interest rates higher, thereby providing support for the yen, as the impact of real rates on the exchange rate is more significant than that of nominal interest rate differentials.
Fiscal fundamentals are not the primary culprit, as the yield increase has already become "excessive." Although there are market concerns about Japan's fiscal situation, recent data shows a clear disconnect between the violent fluctuations in JGB yields and the actual fiscal fundamentals.
From the perspective of fiscal health, Japan's situation is better than that of most developed economies. Since 2023, its public debt-to-GDP ratio has fallen by 11 percentage points, while the developed economies as a whole saw an increase of 2 percentage points over the same period. It is projected that by 2026, Japan's fiscal deficit as a percentage of GDP will be only around 2%, significantly lower than the developed economies' average of 4.9%. Furthermore, the Japanese government's interest payments account for 1.3% of GDP, also far below the developed economies' average of 3.3%.
However, despite relatively sound fiscal metrics, the recent increase in JGB yields has surpassed that of all other major developed bond markets. The core reasons for this "disconnect" lie in market structure and liquidity changes: the trading volume that caused the severe market volatility on January 20 was less than $280 million, reflecting a lack of market depth. Simultaneously, the Bank of Japan's continued reduction of its government bond holdings has led to a disruption in the price discovery mechanism in the absence of a key pricing participant, amplifying short-term volatility.
Inflation expectations are the core driver, but a cooldown is imminent. UBS analysis points out that the recent spike in JGB yields is primarily driven by market inflation expectations, not fiscal deficit pressures. Current Japanese inflation is mainly propelled by structural factors such as food prices (e.g., rice), while underlying services inflation remains at a moderate level of about 1%.
Looking ahead, the bank expects Japan's core inflation rate to fall back to around 1.5% by mid-year. Drawing on the European experience, as supply shocks (such as energy and food price fluctuations) gradually subside, the decline in overall inflation will lead to a synchronous retreat in inflation expectations and wage growth.
Based on a comprehensive assessment, if inflation cools as expected, its effect will be more potent than the Bank of Japan's interest rate hikes in effectively boosting real yields, thereby providing crucial support for JGBs and the yen.
The yen's pricing logic is changing: real rates outweigh nominal spreads. Recently, the traditional correlation between the yen and the nominal interest rate differential between the US and Japan has broken down, with the real interest rate differential becoming the core anchor for its pricing. Models show that based on calculations using the 2-year, 5-year, and 10-year nominal interest rate differentials, the theoretical value of USD/JPY should be around 118. However, if the real interest rate differential is used for estimation, its value is approximately 155, which aligns closely with the current actual market exchange rate.
This discrepancy reflects the market's close attention to Japan's inflation trajectory and its potential threat to monetary policy independence. If future inflation recedes as anticipated, real interest rates will correspondingly rise, thereby providing key support for the yen exchange rate.
Regarding policy responses, UBS analysis indicates that unilateral foreign exchange intervention often has a relatively short-lived effect. In contrast, if the US and Japan can coordinate actions and implement joint intervention (similar to the operational model in June 1998), it would be expected to stabilize the currency market more effectively.
This is not a UK "Truss moment"; Japan's external position remains robust. Addressing market concerns that Japan might replay the 2022 UK gilt crisis, UBS highlights significant differences in key fundamentals and market reactions between the two situations.
Japan holds a massive net international investment position, accounting for a high +92% of GDP, whereas the UK's figure was -2.6% during its crisis. Simultaneously, Japan maintains a current account surplus of 4.8% of GDP, while the UK was in a deficit at that time. The robustness of Japan's external asset-liability structure provides it with a stronger buffer.
From a market performance perspective, the UK crisis manifested as a "simultaneous sell-off in stocks and bonds," whereas the current Japanese stock market, particularly interest-rate-sensitive sectors like real estate and construction, is performing strongly, significantly outperforming the broader market. This indicates the market does not harbor systemic doubts about Japanese sovereign credit.
The real risk: Japanese fund repatriation and the stock market's "external heat, internal cold." The primary spillover risk currently facing global bond markets does not originate from foreign investors selling JGBs, but is more likely to come from large-scale repatriation of domestic Japanese funds from overseas bond markets. UBS points out that as JGB yields have now surpassed the yields of global bonds on a currency-hedged basis, domestic institutional investors in Japan may significantly adjust their allocations starting in the new fiscal year (beginning April 1), shifting funds from overseas bonds to the domestic JGB market.
In the stock market, Japan exhibits a clear structural divergence. Since the start of 2024, just three individual stocks have contributed approximately 55% of the Nikkei 225's gains, indicating a highly concentrated market. Furthermore, this rally has been entirely driven by foreign investors and corporate buybacks, while domestic Japanese individual and institutional investors remain net sellers. This "external heat, internal cold" funding pattern also reflects, from another angle, that local investors remain cautious, likely anticipating persistently high inflation.