Rising Japanese Yields: A Global Liquidity Shock for US Treasuries

🔑 Key Points

• Japanese Yields at Multi-Decade Highs: As of January 2026, Japan’s 10-year government bond (JGB) yields have surged to approximately 2.3%, their highest level since 1999. This rise is driven by the Bank of Japan’s (BOJ) normalization of interest rates and Prime Minister Sanae Takaichi’s expansionary fiscal policies, which include potential tax cuts that threaten to widen the fiscal deficit.
• The "Carry Trade" Unwind & Liquidity Squeeze: The era of "free money" from Japan is ending. As Japanese rates rise, the yen carry trade—borrowing cheap yen to invest in higher-yielding global assets—is becoming unprofitable. This forces a mechanical unwinding of positions, draining liquidity from global markets, particularly US Treasuries, where Japan holds over $1.1 trillion in debt.
• Systemic Risk to US Credit Markets: The greatest systemic risk is not just a sell-off, but a buyer’s strike. High currency hedging costs (driven by the US-Japan rate differential) have effectively erased the yield advantage of US Treasuries for Japanese institutional investors like life insurers. If these investors pivot back to domestic bonds, the US Treasury market could face a "liquidity air pocket," spiking yields and creating a volatility shock comparable to the 2019 repo market crisis.

1. The End of the "Anchor": Why Japanese Yields Are Spiking

For decades, Japan acted as the global financial system's "anchor," exporting massive capital surpluses abroad to escape near-zero domestic returns. In 2026, that anchor is being dislodged.

1.1 The Perfect Storm: BOJ Hiking Meets Fiscal Expansion

The surge in 10-year JGB yields to ~2.3% and 40-year yields touching 4% is the result of a dual shock:

• Monetary Normalization: The Bank of Japan (BOJ) is no longer suppressing yields. With inflation proving sticky, the BOJ has moved to hike rates, signaling that the days of negative or near-zero interest rates are definitively over.
• Fiscal Profligacy: The administration of Prime Minister Sanae Takaichi has spooked bond vigilantes. Proposals for significant tax cuts (e.g., on food) and increased spending have raised fears about Japan's fiscal sustainability, pushing the debt-to-GDP ratio concerns back into the spotlight. Investors are demanding a higher "term premium" to hold long-dated Japanese debt.

1.2 The "Home Bias" Incentive

The mathematical reality for Japanese investors has shifted fundamentally. For a Japanese domestic investor, a risk-free 2.3% yield at home—without currency risk—is increasingly competitive against foreign alternatives, especially when the costs of currency hedging are factored in.

2. The Mechanics of the Liquidity Shock

The transmission mechanism for a global crisis is not political ill will, but cold, hard arithmetic. The "carry trade"—borrowing in yen to buy dollars or other assets—relies on a wide interest rate gap that is now closing.

2.1 The Hedging Trap: Why US Treasuries Are Unattractive

Japanese life insurers and banks typically hedge their foreign currency exposure to avoid losses if the yen strengthens. However, the cost to hedge USD exposure back to JPY is determined by the difference between US and Japanese short-term interest rates.

• The Math: If US short-term rates are ~3-4% and Japanese rates are ~0.75-1.0%, the hedging cost can be upwards of 2-3%.
• The Result: A US Treasury yielding 4.5% minus a 3% hedging cost leaves a "net" yield of just 1.5%.
• The Pivot: Since domestic JGBs now yield 2.3%, the "hedged" US Treasury trade guarantees a loss relative to buying Japanese bonds.

Analysis: Rational institutional capital will flow out of hedged US Treasuries and back into JGBs, or be forced further out the risk curve into lower-quality corporate credit to find yield.

2.2 The "Double Squeeze" in Repo Markets

Systemic risk is highest in the "plumbing" of the financial system—the repo market. US Treasuries are the primary collateral used in global lending. If Japanese banks—who are massive participants in these markets—stop buying or start selling Treasuries:

1. Collateral Velocity Slows: The availability of high-quality collateral (Treasuries) shrinks or becomes more expensive to finance.
2. Liquidity Drain: This mirrors the 2019 Repo Crisis, where overnight lending rates spiked because there wasn't enough cash in the system to absorb the available collateral. A "buyer's strike" from Japan could trigger a similar freeze, forcing the Federal Reserve to intervene with emergency liquidity.

3. Systemic Risks to Global Credit Markets

The impact extends beyond government debt into the broader credit spectrum, affecting corporations and risk assets worldwide.

3.1 Credit Market "Barbell" Risk

Faced with the "Hedging Trap" described above, some Japanese investors (like life insurers) are not just selling; they are taking on more risk. To achieve positive returns, they are:

• Dropping Hedges: Buying US bonds without currency protection ("naked" exposure). If the yen strengthens (a likely outcome of BOJ hiking), they suffer massive capital losses.
• Buying Junk: Moving from US Treasuries to BBB-rated corporate bonds or Collateralized Loan Obligations (CLOs) to find yields high enough to justify the hedging costs.
• Systemic Fragility: This concentrates risk. A US recession that downgrades corporate credit would hit these Japanese portfolios disproportionately hard, forcing a fire sale of assets exactly when liquidity is lowest.

3.2 The Global "Everything Sell-Off"

The yen carry trade funded not just US bonds, but also tech stocks, crypto, and emerging market debt.

• Correlation 1.0: When the carry trade unwinds, it tends to happen all at once. Margin calls on yen loans force investors to sell their most liquid assets (often US tech stocks and Treasuries) to repay debts.
• No Safe Haven: In a typical crisis, investors sell stocks and buy bonds. In a repatriation shock, investors might sell both US stocks and US bonds to bring cash back to Tokyo. This simultaneous drop removes the traditional diversification benefit of a "60/40" portfolio.

4. Counter-Arguments & Mitigating Factors

While the risks are acute, nuances exist that may dampen the shock:

• Pension Funds Don't Hedge: Giant players like Japan's GPIF (Government Pension Investment Fund) often invest with a long-term horizon and do not hedge currency risk. For them, a 4.5% US yield is still superior to a 2.3% JGB yield, assuming the yen doesn't appreciate too dramatically. They may continue to be a source of demand.
• US Dollar Dominance: The sheer depth of the US Treasury market means there are few true alternatives for parking hundreds of billions of dollars. If Japan sells, domestic US investors or other sovereigns may step in, albeit at higher yields.
• BOJ Caution: The BOJ is acutely aware of its impact. It is likely to intervene (via bond buying) to prevent JGB yields from spiking too fast, essentially "smoothing" the exit to prevent a disorderly global crash.

📚 Recommended Topics for Further Exploration

• The 2019 Repo Market Crisis: Understanding the mechanics of that liquidity freeze provides a blueprint for the potential risks of 2026.
• Sanae Takaichi's Fiscal Policies: Deep dive into "Abenomics 2.0" and how fiscal expansion in a high-rate environment differs from the past decade.
• The "Neutral Rate" (r):* Explore how the rise in Japanese global yields effectively raises the "neutral rate" for the rest of the world, enforcing a tighter monetary environment globally.
• US Commercial Real Estate (CRE) Exposure: Investigate the specific exposure of Japanese banks (like Norinchukin) to US CRE, which is another vector for credit contagion.