The Tamesis
Talk of an imminent collapse of Japanese bonds, while inspiring the bull market, has been a surprise. Betting on the collapse of yen-denominated debt tops a list of the world’s top “widow-maker” trades of the past 15 years.
There are many reasons. More than 90% of Japan’s government bonds (JGB) are held domestically, eliminating the risk of large-scale capital flight. They are a major asset held by banks, endowments, insurance companies, pension funds, the postal system and a growing number of retirees. This creates a mutually assured dynamic of destruction that inhibits sales.
And then there’s the Bank of Japan, the ultimate investment behemoth for Japanese government bonds and stock investing via exchange-traded funds. The Bank of Japan first cut interest rates to zero in 1999 and took the lead in implementing quantitative easing in 2001. But in 2013, the central bank began to step up its monetary experiments. By 2018, the Bank of Japan’s balance sheet exceeded Japan’s $4.2 trillion economy, a first among G7 economies.
However, the fallout from the Iran war has thrown global bond markets, including Japan’s, into chaos. In recent days, the 10-year Japanese government bond yield has risen to its highest level since 1996 – over 2.8%.
The main reason for the Japanese government debt collapse is Prime Minister Takaichi Sanae’s fiscal plan for the most indebted major economies. Prior to Japan’s leadership in October, the highs had rattled bond traders on talk of tax cuts and stimulus plans to boost domestic demand.
Even before the war in Iran sent inflation soaring, traders were nervous about an economy with a debt-to-GDP ratio of 260%, hitting fiscal gas. They also worry about Japan’s declining population, chronically weak productivity and the onset of stagflation. The war in the Middle East exacerbated all of these problems simultaneously, putting Japan in danger.
The same is true for other top debt markets. In the United States, the 10-year Treasury yield is well above the psychologically important level of 5%, a 19-year high of around 5.19%. In the UK, both 20-year and 30-year government bond yields rose to their highest levels since 1998. German long-term government bond yields hit a 15-year high, the highest level since the European debt crisis. Australian and New Zealand government bonds performed poorly in May.
The financial chaos may have just begun. Nearly 100 days after U.S. President Donald Trump tried to declare victory over Iran, markets are beginning to accept the reality that the war could continue. The longer crude remains above $100 a barrel and the longer the Strait of Hormuz remains essentially closed, the greater the economic derailment in 2026.
That, coupled with the artificial intelligence boom, has pushed stock valuations from New York to Seoul through the roof. Artificial intelligence trading has helped South Korea’s Kospi index rise 67% so far this year and 177% over the past 12 months. Taiwan’s stock market is up 36% so far this year and 86% over the past 12 months. If the oil-related fallout spreads to Asian markets, some stock markets in the region could fall sharply.
Same goes for Japan. So far this year, the Nikkei 225 is up 15%. This is despite the Bank of Japan predicting that inflation will rise to 2.8% this year and the economy will grow by only 0.5% at best. Wage growth has not kept pace, especially among small businesses that employ 76% of Japanese workers.
“The limited prospects for wage growth among small businesses may mean that the Bank of Japan will continue its gradual and cautious process of normalizing monetary policy,” said Shigehito Nagai, chief Japan economist at Oxford Economics. “Especially given that small businesses are particularly vulnerable to terms-of-trade shocks stemming from the Middle East crisis.”
With global markets in disarray, only time will tell whether the trade that led to the collapse of Japanese government bonds will ultimately pay off. At least one thing is clear, though, and that’s that for debt traders everywhere, this is a time to buckle up.
