The Bank of Japan has just delivered a shock to the global financial system, raising its benchmark interest rate to its highest level in 31 years. For two decades, Japan was the world’s cheap money factory, exporting deflation and suppressing yields everywhere. Now the spigot is turning off.
British bond markets are already feeling the tremors. The 10-year gilt yield has spiked 15 basis points this morning, as global investors recalibrate the ‘carry trade’ that has funded decades of Japanese money sloshing into higher-yielding Western government debt. This is not a done deal and the situation is fluid. But make no mistake, the era of free Japanese capital is ending.
The mechanism is brutally simple. Japanese institutional investors, the largest holders of foreign bonds outside the United States, now have a domestic alternative that actually pays a decent return. For the first time in a generation, a Japanese government bond offers something approaching a risk-free real yield. Why buy gilts yielding 4.5% when you can buy JGBs yielding 1.5% without currency risk? The answer is, you don’t. You repatriate.
This capital flight has profound implications for the UK. The Chancellor’s fiscal arithmetic already looked dodgy with the Office for Budget Responsibility pencilling in lower gilt yields. Now those assumptions are in tatters. With the Bank of England holding rates steady at 5.25%, the yield gap between UK and Japanese bonds is narrowing fast. Sterling is getting crushed, down 2% against the yen this morning alone. That stokes imported inflation, making the BoE’s job even harder.
The BoJ’s move is also a direct challenge to the Bank of England’s credibility. Governor Kuroda spent years apologising for generating inflation. Now his successor is doing what Haldane and company never dared: normalising rates. Meanwhile, Threadneedle Street is stuck between a sticky services sector and a recessionary vibe. Market expectations for a rate cut in August have evaporated.
But here’s the real worry. Japan’s rate rise is not a one-off. They have signalled more to come. If the yen strengthens further, the carry trade unwinds with a vengeance. This is a slow-motion train wreck for global bond markets. UK pension funds, already reeling from the Liability-Driven Investment crisis of 2022, are exposed. Their hedges against falling yields will now bleed cash as yields rise.
The City is buzzing with unease. The usual suspects are calling it a buying opportunity. I call it a secular shift. Japan’s demographic time bomb means they need domestic savers to fund the government’s debt, not foreign adventures. This is not a blip. The Bank of Japan has ended the era of free money. The rest of us will have to pay the price.
