High yields on Japanese bonds, a weak yen, and a strong stock market coexist: How much longer can the fragile re-inflation trade last?

Since May, the Japanese government bond market has been continuously experiencing sell-offs, with the 20-year Japanese bond yield rising to 3.498%, reaching a new high since 1997; the 10-year and 30-year yields have rebounded after significant volatility, climbing to 2.59% and 3.86% respectively, approaching new highs. Yields across key maturities are showing a broad and steep upward trend.

The outlook for the Middle East situation remains uncertain, oil prices stay high, imported inflation heats up again, and U.S. CPI exceeds expectations, spilling over into higher U.S. Treasury yields. Coupled with market concerns over Japan’s fiscal expansion and debt sustainability, multiple factors are jointly driving the sell-off in Japanese bonds.

On the other hand, the continued rise in Japanese bond yields is accompanied by a persistent weakening of the yen. Although the Japanese government intervened multiple times during late April and the Golden Week (May 3-5), injecting about 10 trillion yen (approximately $63 billion) into foreign exchange markets, unilateral intervention alone cannot alter the fundamental constraints. The yen temporarily appreciated but then continued its depreciation trend, currently at 157.9, depreciating 1.87% from the high of 155.0 on May 6.

As a global reservoir of cheap funds, rising Japanese bond yields will attract slow capital reflows into Japan, prompting a gradual reversal of arbitrage trades. This puts pressure on valuations of U.S. Treasuries, European bonds, and global growth stocks. However, the main driver of arbitrage trading currently is the yen exchange rate rather than interest rates, because the real interest rate differential between the U.S. and Japan remains positive, and the structural depreciation trend of the yen persists, maintaining Japan’s low-cost financing advantage.

Currently, Japan’s stock market benefits from the decline in geopolitical risk premiums and strong performance of U.S. tech stocks, with the Nikkei 225 breaking through the 63,000-point mark. As long as bond and foreign exchange markets do not lose confidence in the re-inflation policies, high yields, a weak yen, and robust stocks can coexist.

However, a 10-year yield exceeding 2.50% (the upper limit of Japan’s estimated neutral interest rate) signals a warning for re-inflation policies. Additionally, the neutral rate expectations, represented by the 5-year forward OIS rising to 2.54%, are being brought forward, indicating that the interest rate market is beginning to resist the re-inflation policy. Furthermore, if yen arbitrage trades become excessively inflated due to the Bank of Japan lagging behind the curve (low interest rates and a weak yen), a forced unwind could trigger sharp corrections in the stock market.