The Japanese market is undergoing a significant turning point, marked by a fundamental shift in its pricing logic. Following the Liberal Democratic Party's overwhelming victory in the general election, the yen yield curve has flattened, inflation expectations have stabilized, and the yen has strengthened. This represents a typical reaction seen in developed markets when facing expectations of higher real interest rates.
According to a recent research report from Goldman Sachs, the market has begun pricing in the possibility of Japan exiting its ultra-low real interest rate regime, moving beyond viewing the situation merely as an inflationary shock. The core driver of this change is investors assigning a higher probability to expectations of asset repatriation and an exit from the ultra-low rate environment.
However, significant uncertainty remains regarding the sustainability of this shift. Goldman Sachs warns that if the Bank of Japan fails to deliver on the more hawkish path anticipated by the market, previous dynamics could re-emerge, potentially leading to a weaker yen and increased volatility in long-term interest rates.
The report highlights that key risks are concentrated on the Bank of Japan's policy trajectory. Any signs of dovishness from the central bank regarding accelerating the pace of rate hikes—particularly given the yen's recent strength—could catalyze a return to pre-election trading patterns.
Market pricing logic has undergone a fundamental transformation. Two weeks ago, Goldman Sachs analysts proposed a framework for understanding Japanese Government Bond and yen performance under the current policy mix. The logic then was that simultaneous weakness in bonds and the currency was a reasonable market response, given constrained policy rates, rising inflation, and planned fiscal expansion.
Post-election, however, the market has displayed截然不同的 dynamics. Real interest rates have edged higher, while forward inflation expectations have slightly declined. Equities have risen alongside a flatter nominal yield curve and a stronger yen. Goldman Sachs views this cross-asset reaction as clear, consistent, and aligning with typical correlation patterns in developed markets when actual inflation nears target levels.
Data shows a noticeable divergence in the paths of 2-year and 3-year forward real swap rates and inflation swap rates since the second half of 2025, with real rates steadily rising and inflation expectations stabilizing.
The key to the shift in market pricing logic, according to Goldman Sachs, lies in investors beginning to assign greater weight to the probabilities of portfolio flow shifts and an exit from the ultra-low real rate regime. Combined with market expectations for new fiscal measures, these movements are largely consistent with pricing in an increased likelihood of repatriation of assets tied to Japan's strong net international investment position.
Some investors have interpreted recent comments from the Finance Minister as signaling support for the repatriation of foreign assets. Given Japan's substantial net international investment position, utilizing overseas assets to fund new fiscal expansion, or shifts in private sector portfolio flows and FX hedging, could stabilize the yen and boost other domestic asset prices.
Notably, recent market moves have substantially narrowed the gap with Goldman Sachs's model predictions. The actual level of the 10-year to 30-year Japanese Government Bond spread is now close to the model's fitted value, suggesting the market is indeed pricing a different regime post-election.
The sustainability of the current market dynamics hinges critically on whether Japan can genuinely exit the ultra-low real interest rate regime. Goldman Sachs points out that Japan's structural challenges and policy debates could make this transition difficult or prolonged.
The bank suggests that if the recent yen strength persists, the Bank of Japan is likely to adopt a more patient stance. This could reignite pre-election dynamics, where a weaker yen was a key prerequisite for faster rate hikes.
Given the current pricing of the policy path and the market's exploration of an exit from the low real rate environment, any dovish signals from the BOJ regarding accelerating the pace of hikes could catalyze a return to pre-election trading patterns.
Regarding the policy path, the market currently sees only the March meeting offering a compelling risk-reward profile, pricing in 7 basis points.
Even if the risks of a weaker yen and a steeper long-end of the yield curve resurface, this would not constitute Japan's inflation equilibrium, according to the report. Goldman Sachs believes that without a decline in the inflation outlook, interest rate volatility in the middle part of the yield curve (around the 5-year point) is unlikely to decrease.
Data reveals a clear correlation between the 5-year to 30-year swap spread and the volatility spread. As the 5-year to 30-year swap spread has increased from around 0.8% at the start of 2024 to current levels, the implied volatility spread between 30-year and 5-year rates has also widened significantly.
This volatility pattern suggests greater risk of a flatter yen yield curve over the longer term, Goldman Sachs argues.
In the short term, the current market conditions could extend further during the information vacuum over the coming weeks. However, Goldman Sachs's inclination is to view this move as potentially "too much, too soon." If the Bank of Japan uses the opportunity presented by recent yen strength to maintain a more gradual hiking path, renewed yen weakness and increased long-end rate volatility could follow.