17.08.2026 - Japan - Walking on the Edge

Japan is increasingly becoming one of the most important risks for global financial markets.

The Japanese economy expanded at an annualized rate of just 1.1% in Q2 2026, slowing from a revised 1.9% in the previous quarter and clearly missing market expectations of around 2.0%. On a quarterly basis, GDP increased only 0.3%. Private consumption was essentially flat, while business investment weakened, highlighting the fragility of domestic demand.

The Japanese yen remains extremely weak, increasing the cost of imported goods and energy and therefore adding to inflationary pressures. Meanwhile, Japanese government bond yields continue to rise.

Today, the 10-year Japanese government bond yield reached 2.93%, its highest level since 1996. Markets are increasingly pricing the possibility that the Bank of Japan will have to tighten monetary policy further in order to stabilize inflation expectations and the yen.

Markets:

• Equities: Japan’s Nikkei 225 Index is close to record highs.

• Bonds: Japan's 10-year government bond yield reached 2.93%, its highest level in around three decades

• Currencies: The Japanese yen is weakening again, moving back towards the critical USDJPY 160 area despite the recent intervention

My View: Japan in an increasingly uncomfortable position:

Weak economic growth.
Weak currency.
Persistent inflation pressures.
Rising interest rates.
Rising government borrowing costs.

And all of this is happening in a country carrying one of the largest government debt burdens in the developed world.

Japan is caught in a difficult policy loop. A weaker yen increases import prices, particularly for energy and commodities. That adds to inflation.

Higher inflation increases pressure on the Bank of Japan to raise interest rates. Higher interest rates push Japanese government bond yields higher. And higher yields ultimately make refinancing Japan's enormous government debt increasingly expensive.

The problem therefore becomes self-reinforcing. But this is not an isolated Japanese issue.

Japan is also the largest foreign holder of US Treasury securities, with holdings of more than USD 1.1 trillion. That creates another important connection.

When Japan intervenes to support the yen, it needs foreign currency resources to buy yen. Selling or mobilizing foreign reserve assets, including US Treasury holdings, can therefore create additional pressure on the US Treasury market.

This matters because the United States itself has little interest in seeing Treasury yields rise substantially further.

The US government already faces an enormous refinancing burden. Treasury data show USD 867 billion of interest expense fiscal-year-to-date, while recent estimates put US government interest costs at roughly USD 3 billion per day.

Higher Treasury yields would make that problem even larger. This helps explain why the recent currency intervention was so remarkable.
At the end of July, the United States joined Japan in supporting the yen, an unusually coordinated intervention. The US Treasury sold reserve assets and purchased yen alongside Japan, while additional mechanisms were discussed to give Japan access to dollar liquidity without forcing large sales of US Treasuries.

There is therefore a clear alignment of interests: Japan wants to prevent further yen depreciation. The US wants to avoid Japan having to aggressively liquidate Treasury holdings to defend its currency.

But the effect of the intervention is already fading. The yen initially strengthened sharply following the coordinated action, but has since weakened again towards 160 against the US dollar.

And there is another reason why investors should watch Japan extremely closely: The Yen Carry Trade.
For decades, Japan's extremely low interest rates made the yen one of the world's most important funding currencies.

Investors could borrow cheaply in yen and invest the proceeds in higher-yielding assets elsewhere.

As long as Japanese interest rates remained low and the yen remained weak or stable, this strategy worked extremely well. But the mechanism can also move violently in reverse.

If Japanese interest rates rise substantially or the yen suddenly appreciates, investors using yen-funded positions may be forced to reduce those trades and buy yen to repay their borrowing.

That can create a powerful feedback loop: Yen strengthens → carry trades lose money → investors reduce leverage → assets are sold → yen is bought back → yen strengthens further.

The risk is therefore much bigger than Japan itself. A rapid yen appreciation or sharp BoJ tightening could trigger a disorderly large-scale carry-trade unwind and forced a large-scale deleveraging across global financial markets, putting pressure on equities, bonds and other risk assets simultaneously.

This is why Japan deserves far more attention from global investors. The Bank of Japan and political leaders are effectively walking on the edge.

For now, policymakers have managed to keep the system relatively stable. But the room for policy mistakes is getting smaller.

Japan may currently be one of the most underestimated transmission risks for global financial markets.

Become a member to access more valuable market updates like this