Japan’s bond market: the end of interest rate rigidity 

• Giorgio Gaballo
  Fixed Income Portfolio Manager
  Eurizon

Inflation is changing the rules of the road

The rise in yields should be understood less as a short-term normalisation and more as an expression of changing fundamentals. Inflation is no longer considered a temporary phenomenon. Rising wages and changed price dynamics have permanently altered the macroeconomic environment. At the same time, the Bank of Japan has abandoned key pillars of its ultra-loose policy: yield curve control and negative interest rates are now a thing of the past. At the same time, the reduction of the central bank’s balance sheet began in 2024 and is likely to continue until 2026/2027.

This marks the end of an era in which Japanese government bonds were primarily synonymous with stability and low volatility. Yields are once again reacting more sensitively – to inflation expectations as well as to the term premium and the investor base. This new reality is particularly evident along the yield curve.

The short end remains comparatively well anchored, supported by the central bank’s continued gradual approach, whileat the long endvolatility has increased. The decisive factor here is not so much supply as unreliable demand. One possible source of support would be for the government to shift its issuance more towards maturities of up to ten years, thereby easing pressure on the long end. The main reason for this is the change in the buyer base and the increased exposure of the long end to foreign investors’ sentiment. Domestic institutions such as banks, life insurers and pension funds are acting more selectively, while international investors are gaining influence on pricing. This has favoured a steepening of the yield curve and heightened volatility– especially in the 10- to 30-year segment – in an environment of low market liquidity At the same time, sensitivity to shifts in sentiment is increasing.

Duration becomes an active decision

This means that duration is no longer a purely technical indicator, but once again a strategic decision. The Bank of Japan is considered to be somewhat “behind the curve” in this regard, thereby increasing upward pressure on yields. The question is no longer whether duration risk exists, but where along the yield curve it should be consciously taken. Political and fiscal events can have a noticeable impact on the interest rates. Risks and opportunities stem from the same source: fiscal policy. However, this sends a mixed message to investors: heightened uncertainty on the one hand and new opportunities on the other. Market overreactions generate entry points that hardly existed in the previous low interest rate environment.

Conclusion: A market in transition  

Japan’s bond market is thus no longer a market characterised by predictable inertia. Instead, it is evolving into an environment that is more strongly influenced by fundamentals i.e. inflation, and fiscal and monetary policy. Volatility is increasing – and so is the importance of active management. For investors, this calls for a shift in perspective: passive exposure is giving way to selective duration positioning. Those who actively manage duration, curve positioning and risk premiums will find that Japan is once again a market of strategic relevance.