Weekly Update - Japan: interest rates rediscover inflation
One of the most notable financial developments at the start of the year has been the significant rise in Japanese sovereign yields: the 10 year JGB reached 2.2%, its highest level since 1995. While this increase was accelerated by the announcement of early elections on 8 February and the prospect of a more expansionary fiscal policy, it is also part of a deeper upward trend that began in 2022, as Japan gradually emerges from two decades of deflation. In a context where inflation and nominal growth are expected to remain durably higher, Japanese interest rates are “normalising” and should stay at elevated levels. Paradoxically, this new environment is supporting equity markets, buoyed by more robust growth and a weaker yen that boosts the repatriation of dividends.
Early elections accelerating the rise in sovereign yields. The beginning of the year has been marked by intense political developments. Newly appointed Prime Minister Sanae Takaichi dissolved the Lower House and called early elections for 8 February, aiming to expand her majority. Her main economic proposal is the two year removal of taxes on food products, a measure synonymous with expansionary fiscal policy. This announcement triggered a sharp rise in long term rates: the 10 year yield reached 2.2%, the 30 year yield 3.5%, both at their highest levels since 1995. At the same time, the yen depreciated sharply, nearing 160 yen per dollar before recovering on the back of rumours of Bank of Japan (BoJ) interventions and a weakening U.S. dollar. Conversely, equity markets reacted positively, with the Nikkei 225 up 6% since the start of the year.
A rise in yields that reflects the end of deflation. The oft mentioned risk of higher yields driven by concerns over public debt sustainability — which stands at around 200% of GDP — appears limited. The Japanese economy has in fact benefited from significant fiscal consolidation since the Covid crisis, as well as structurally high current account surpluses. The increase in yields mainly reflects the exit from the long deflationary period and fears of overheating. After more than twenty years of falling prices, inflation has been back in positive territory since 2022: headline inflation now exceeds the BoJ’s 2% target, while core inflation hovers around 1.5%. Coupled with stronger real growth, this return of inflation is boosting nominal growth, thereby reducing fiscal risk. But this regime shift has pushed the BoJ to unwind its ultra accommodative monetary stance: a gradual phasing out of balance sheet controls and incremental policy rate hikes since 2024. In this context, the risk associated with new fiscal measures is that they could fuel additional inflationary pressure, forcing the BoJ to accelerate normalisation.
A new environment supportive of Japanese equities. While rising nominal growth is putting upward pressure on yields, it is proving favourable for equity markets. Since 2022, the Nikkei 225 has gained 100%. This exceptional performance is driven by: rising corporate revenues, supported by stronger nominal growth; a weak yen, which boosts profits earned abroad and enhances competitiveness. In this new macroeconomic environment — stronger nominal growth, a weak yen, and more accommodative fiscal policy — Japanese equities should continue to perform well, reinforcing our positive view on this asset class.
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