Japan's interest rates have remained near zero for a long time. In order to support the domestic market, the Bank of Japan has bought up almost all available assets in the domestic market, while investors regard the yen as an inexhaustible source of financing.

Just as in August 2024, the country once again broke its usual low profile—Japanese government bond yields soared to their highest level since 2008, plunging the market into violent turmoil.

This volatility not only pushed US Treasury yields back above 4% and impacted the European bond market, but more importantly, it also severely damaged the stock and highly leveraged markets.

Many investors are questioning whether the Japanese bond market foreshadows future trends, as they view Japan as a global "cheap money machine," and what the consequences would be if this machine failed.

The government's motivation for issuing bonds and the central bank's operations led to a surge in Japanese bond prices.

This week, the yield on Japan's 10-year government bonds touched approximately 1.89%, a new high in nearly 17 years; the 2-year yield broke through 1% for the first time since 2008, while the 30-year yield climbed to a historical peak of nearly 3.4%.

This surge was by no means unexpected. Bank of Japan Governor Kazuo Ueda has clearly stated that the central bank's board of directors will "weigh the pros and cons of raising interest rates again" at its meeting on December 19.

The market generally believes that the policy interest rate, which just escaped negative interest rate territory earlier this year, is highly likely to be raised again.

Meanwhile, the new government led by Prime Minister Sanae Takaichi approved a supplementary budget of approximately 18.3 trillion yen, of which 11.7 trillion yen was primarily financed through newly issued bonds. Japan's public debt has exceeded 230% of its GDP, ranking first among major economies.

Central banks are gradually phasing out their long-standing yield curve control (YCC) policy, while governments are relying more heavily on the bond market to finance new stimulus programs.

Therefore, investors demand higher returns in order to hold these bonds.

How do fluctuations in Japanese bond yields affect US Treasury yields and global assets?

The end of Japanese carry trades tightened market liquidity, and the rise in Japanese bond yields accelerated expectations of yen appreciation and increased expectations of higher borrowing costs. This expectation transmission effectively removed some liquidity from those hoping to borrow yen to invest in high-yield assets, thus directly restricting market liquidity.

The core logic of the "yen carry trade" is that Japan keeps interest rates pegged to near zero for a long time, while other parts of the world can offer higher returns.

Once the yields on 2-year and 10-year Japanese bonds become attractive, this arbitrage logic will change.

Some investors have begun repaying yen financing and reducing their holdings of overseas assets; others will think twice before buying the next batch of US or European bonds.

This shift in sentiment can drive price changes without requiring large-scale panic selling of funds.

This will affect the source of arbitrage funds, as evidenced by the recent plunge in non-equity risk assets. At the same time, precious metals will also be affected.

This time, investors are not rotating within risky assets, but are actually deleveraging and repatriating cash.

Rising Japanese bond yields trigger panic selling in global bonds.

On the same day that Japanese government bond yields surged, the yield on the 10-year U.S. Treasury note jumped to approximately 4.08%-4.09%, its highest level in nearly two weeks.

If investors can obtain a return of close to 2% in a stable currency at home, then the exchange rate and political risks associated with holding US bonds with a 4% yield seem to outweigh the extra returns.

Japan is the world's largest creditor nation, with net overseas assets exceeding $3.6 trillion. As interest rate spreads narrow and even a small portion of these funds are sold off or flowed back to Japan, global term premiums will rise.

This pressure is reflected in various asset classes: the correlation coefficient between the 30-year yields of Japanese and German bonds is as high as 0.78, and the yield on German government bonds has risen to about 2.75%.

The difficulties faced by American businesses, compounded by dismal economic data, have exacerbated the situation.

At the time, the futures market indicated that the probability of the Federal Reserve cutting interest rates again this month was close to 90%.

From factory surveys to employment data, various economic indicators are showing weakness. For example, the US ISM PMI index released on Monday fell below the 50-point mark for the 37th consecutive month.

According to textbook logic, this should lower long-term yields rather than raise them, but the concentrated issuance of bonds by some companies has added fuel to the fire.

Earlier this week, a wave of corporate bond issuance in the United States put pressure on the bond supply side, with Merck leading an $8 billion bond issuance.

When companies issue bonds in droves, and the government also needs financing, investors will demand higher yields in order to take on all these debts.

With global economic data continuing to deteriorate, many countries are facing the predicament of governments and businesses needing to issue bonds.

Cheap capital supply machines are no longer cheap.

This is what global investors see as a "cheap money supply machine": obtaining yen funds at near-zero or even negative interest rates, then reinvesting in high-yield assets to earn interest rate differentials, with almost no additional costs—this is the core benefit of this "machine".

However, this "cheap machine" has never truly operated "cost-free". Its hidden costs are actually borne silently by three types of entities: First, Japanese domestic savers. The interest rate on Japanese household deposits has been kept below 0.1% for a long time, and the returns on fixed-income assets of institutions such as pension funds and insurance companies have been continuously suppressed. In essence, the wealth returns of domestic residents have been used to subsidize global arbitrageurs.

Secondly, for holders of yen, the Bank of Japan's ultra-loose monetary policy to suppress interest rates will inevitably lead to a long-term depreciation of the yen, and individuals and businesses holding yen will have to suffer losses due to reduced purchasing power.

Thirdly, regarding Japan's real economy, although the low-interest-rate environment was intended to stimulate the economy, a large amount of cheap capital did not flow into domestic industries. Instead, it flowed out through carry trade, exacerbating the hollowing out of domestic industries. Ultimately, Japanese taxpayers indirectly paid the price through fiscal subsidies and insufficient investment in public services.

The core logic of the "yen carry trade" is that Japan keeps interest rates pegged to near zero for a long time, while other parts of the world can offer higher returns.

The interest rate differential earned by arbitrageurs is essentially the difference between the benefits of Japanese policy and the returns of the global market. In essence, it is a "subsidy" provided by the Japanese economy to global investors at a hidden cost, which is also the core operating logic of this "cheap machine". Of course, the high interest paid by countries such as the United States is also part of the subsidy.

The shutdown of this "cheap machine" that had been running for thirty years was essentially because the Japanese economy could no longer afford the cost of this implicit subsidy. Population aging led to a shrinking savings pool, high debt made the low-interest-rate policy unsustainable, domestic funds began to demand reasonable returns, and the cost advantage of global arbitrage naturally disappeared.

Trading Implications:

The rise in Japanese government bond yields is a result of hawkish comments from the Bank of Japan, the central bank's exit from the yield curve control (YCC) program, and the introduction of stimulus fiscal policies domestically. In other words, the 10-year yield equals the nominal interest rate plus inflation expectations plus interest rate compensation.

This could lead to a potential appreciation of the yen in the near term, but the long-term trend of the yen will still depend on domestic fundamentals and import/export conditions.

Rising Japanese government bond yields worsened liquidity in the arbitrage market, leading to downward pressure on risk assets, particularly high-leverage instruments reliant on cheap funding.

The US dollar has broken out of its downward trend due to domestic data, interest rate hike expectations, and the potential appreciation of the Japanese yen, which is beneficial to commodities and most investment products.