Don’t Heed Panic-Mongers On Japanese Interest Rates Or Yen

As Takaichi Opens Fiscal Faucets, JGB Rates Move Up And Yen Ratchets Down

Source: Wall Street Journal

In 2002, traders in bonds and currencies joked: “What’s the Difference Between Japan and Argentina?” The answer: “Two years.” They were sure that Japan’s massive government debt was about to end with a crash of bond prices and an explosive rise in interest rates. So, traders sold like mad Japan Government Bonds (JGBs) that they had borrowed and thereby lost their shirts. The JGB gambles became known as “the widow-maker.”

We may soon see a new generation of widows because alarmism is breaking out among some traders, alleged experts on social media, and media outlets like Yahoo Finance. The trigger was a smallish rise in JGB yields, sparked by new Prime Minister Sanae Takaichi opening the fiscal faucets. The yield on 10-year JGBs is approaching 2%, the first time it’s been that high since 2006 (see chart above). Sensationalist headlines screamed “all-time record high yields” on the 30-year JGB when it hit above 3.4% in November; the headline writers failed to note that the 30-year bond did not even exist until 1999, when Japan was already well on its way to zero interest rates. So it has never seen normal rates.

Then, there are those who forecast that the “death of the yen carry trade”—borrowing at low interest rates in Japan to invest in the US—will send US interest rates skyward. If so, how come the big drop in foreign holdings as a share of federal debt over the past dozen years—from 34% to 25%—has not already done so?

In an April 2025 “Fact Sheet,” the Ministry of Finance—which has been crying wolf about a “fiscal emergency” for a half-century—pointed out that Moody’s rates Japan’s government debt at just A1, five notches below Aaa. So what? In the past half-century, no country with an A1 credit rating has defaulted while still holding that rating. Greece is the only country I’ve found that had an A1 rating and then subsequently went into crisis and defaulted. Japan has held the A1 rating for more than a decade, and at various times has had a lower rating.

Five Reasons Not to Expect A Crash

There was no reason to expect a crash two decades ago and even less reason to expect one now.

While the Bank of Japan (BOJ) is widely predicted to raise the overnight rate this month to 0.75%, the highest rate in three decades, this is most likely the overnight policy rate catching up to market-determined long-term rates rather than a trigger for another spike upwards in the latter.

Secondly, 88% of JGBs are held by domestic investors, mostly institutions, including the BOJ, and they are not about to bail. The only countries that went through the Eurodebt crisis in 2010 were those suffering “twin deficits.” Not just enormous government debts, but also huge international debts (the countries with big black squares in the lower right quadrant of the chart below). There were no crashes among those with large internal debts but large international creditor status, like Japan (upper-right quadrant).

Source: Author calculation based on data in https://www.oecd.org/content/dam/oecd/en/publications/reports/2011/05/oecd-economic-outlook-volume-2011-issue-1_g1g11686/eco_outlook-v2011-1-en.pdf

Thirdly, many analysts discussing Japan’s massive debt-to-GDP ratio mistakenly refer to gross debt. But that includes the debt that one government agency owes to another, including the BOJ. Risk of capital flight only lies in that portion held by private investors, the net debt. And the latter is smaller than it’s been in decades, mainly because the BOJ has bought so much of the debt since 2013. In early 2013, net government debt held by private creditors peaked at 144% of GDP. Today, it equals just 96% (see chart below).

Source: MOF at http://www.mof.go.jp/english/jgbs/reference/gbb/index.htm and Bank of Japan Code BS01’MABJMA5B at http://www.stat-search.boj.or.jp/index_en.html

Fourthly, the combination of reduced net debt and ultra-low interest rates has lowered net interest payments at all levels of government to a trivial 0.03% of GDP in 2024, down from nearly 1% in 2012 (see chart).

Source: OECD at https://tinyurl.com/2vavu2b3

Much of the debt is held at long maturities, and the latter won’t need to be rolled over for years. As a result, it will take a long time for the average interest rate to catch up to the rise in spot rates in the market. The MOF estimates that its gross interest payments on national JGBs will rise slowly from ¥10.5 trillion in the current fiscal year, about 0.15% of GDP, to ¥16 trillion three years from now. This assumes a rise in the long-term interest rate to 2.5% by 2028.

Finally, interest rates are not rising at a “rather rapid rate” as BOJ Governor Kazuo Ueda claimed. On the contrary, the pace of today’s hikes is still the same as has prevailed since 2021 (see the trendline in the chart at the very top).

We get an even more representative picture of recent rises if we use a logarithmic scale. The regular scale at the top of this post shows every time the interest rate rises by 0.02%. But a rise from 0.02% to 0.04% is a doubling of the yield, whereas an increase from 1.8% to 2.0% is just 11%. On the log scale in the chart below, each horizontal line shows when the interest rate has doubled. It demonstrates that recent ups and downs are far less volatile than past ones.

What makes this stability particularly telling is the fact that, while foreign investors own just 12% of JGBs, they account for half of all daily JGB trades on the spot market and 76% on the futures market. If capital flight were coming down the runway, interest rate hikes would not have risen so gradually.

Slow Corrosion Rather Than A Crash

None of this means there are no consequences to Japan’s massive buildup of government and its reliance on the BOJ to “monetize” it. Rather, the consequences manifest not as a financial crash but as slow corrosion of the economy.

Money has been wasted on “bridges to nowhere,” fossil fuel subsidies, and other boondoggles, rather than measures that boost long-term growth, like the government paying a higher share of college tuition to ensure that less affluent youth can attend. Decades of submarket interest rates have kept zombies on life support at the expense of healthier companies. Consequently, as I’ll discuss in a soon-to-be-published post, a stunning half of Japan’s GDP is produced in business sectors where (total factor) productivity is actually falling, not just decelerating.

By the way, it’s essential to keep in mind that chronic deficits are more the symptom of economic weakness than its cause.

Yen Ratches Down Under Takaichi

The value of the yen vis-à-vis the dollar has taken another ratchet downward in the Takaichi era. This, too, has set off false alarms. Contrary to the mid-November statement by Finance Minister Satsuki Katayama, currency movements are neither “extremely one-sided and rapid.” The dark line in the chart below shows the yen’s percentage movement over 30 days. The dotted lines show “one standard deviation,” i.e., the 4-percentage point range containing two-thirds of the changes. As we can see, at its most volatile this November, the 30-day movement was far closer to the dotted line than in previous hikes. It is now fairly close to zero.

Still, the yen’s decline would seem to be a bit of a surprise. Since Takaichi’s fiscal largesse has raised interest rates in Japan, that has narrowed the rate gap between 10-year government bonds in America vs. those in Japan, albeit at no greater rate than has been happening since early this year (see chart).

That, in turn, should lure less money from Japan into the US and therefore reduce the need to convert yen into dollars (the “yen carry trade”). As shown by each trendline in the chart below, the narrower the rate gap, the stronger the yen (lower numbers indicate a stronger yen).

However, something strange has happened of late. Under Takaichi, the rate gap has narrowed, as shown by the markers in the Takaichi era moving to the left, i.e., a smaller rate gap than in recent years. Yet, instead of the yen recovering, it has fallen further, as seen in the downward movement of the markers.

Aberration or Harbinger?

Is this just a temporary aberration? Or is this a sign of a further ratcheting down of the yen’s value that we’ve seen over the past couple of decades? We can see this downward movement by comparing the trendline for 2001-2012 to the trendline for 2021 through October 15^th of this year. And now the yen/$ in the Takaichi era is far below the trendline of the past five years.

Today, the rate gap between American and Japanese 10-year bond rates is just 2.2%. When the rate gap was at that level in 2001-12, the predicted rate of the yen was about ¥100. During January 2021 through October 15^th, the expected yen at the same rate gap was ¥127. But today the yen is fluctuating far lower at ¥156.

It is possible the yen’s weakness has overshot somewhat, but several changes in fundamentals have given the yen good reason to weaken substantially.

Firstly, the 43% depreciation of the yen since 2021 has not boosted Japan’s exports as much as expected. Real exports are up just 5% in the last three years. That suggests Japanese exports are less competitive than traders previously assumed, and a reassessment on this front reduces demand for the yen. The Trump trade war could hurt Japan’s exports even more. In July-September, Japan’s real trade surplus in goods and services fell at a 15% annual rate.

Now look at the nominal goods and services trade balance, which not only reflects competitiveness but also directly affects the balance of payments and thus demand for the yen. During 1994-2010, Japan enjoyed an average nominal trade surplus equal to 1.2% of GDP despite a price- and currency-adjusted yen at a strong index number of 134 (a higher index number means a stronger yen). During 2011-2020, Japan ran a nominal trade deficit despite a much weaker yen at an index number of 105; a weaker yen should have made Japan’s exports more competitive. In 2021-2025, the real yen was even weaker, at 78, and yet the trade deficit was even bigger at 1.5% of GDP.

Source: Author calculation based on data from Bank of Japan and Cabinet Office

Finally, Japan’s stagflation could make foreign and Japanese investors worry about future corporate profits, and therefore become less interested in investing in Japanese stocks. That, too, reduces demand for the yen.

The future is very uncertain. Forecasters even disagree about whether the yen will strengthen or weaken in the next couple of years. But a return to the level of five years ago seems very unlikely to me.

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