Japan, the end of an era

The last time Japan’s policy rate was as high as 0.75% was in 1995. Thirty years later, the Bank of Japan has reached that same threshold again. Governor Kazuo Ueda raised the policy interest rate from 0.5% to 0.75% last Friday, the second 25-basis-point increase this year. It is a cautious but significant step away from the world’s largest and longest-running monetary experiment. For decades, Japan has pursued ultra-loose monetary policy to combat deflation. With inflation stubbornly hovering above 3%, the central bank has little choice but to tighten the reins. For American or European investors accustomed to looking to the Federal Reserve or the ECB, a Japanese interest rate hike may seem like an event in a distant land. Japan is unique in the global financial system, but what happens there can send shock waves worldwide.

Bank of Japan policy rate

The carry trade: free money is gone

The core of Japan’s global influence lies in the so-called carry trade. For years, the Japanese yen was the currency of choice for cheap borrowing.

Hedge funds and institutional investors borrowed massively in yen at virtually zero interest rates, then invested that money in higher-yielding assets: US government bonds, European equities, and emerging markets. The difference in interest rates was pure profit, as long as the yen remained weak.

Paradoxically, this mechanism made the yen a safe haven. When financial turmoil struck, carry traders sold their positions and switched back to yen to repay their loans. As a result, every time there was stress on the markets, the yen rose. An appreciation of the Japanese currency went hand in hand with falling share prices and increasing volatility elsewhere.

Now that Japan is raising interest rates, this game is fundamentally changing. Rising interest rates make borrowing in yen more expensive and usually lead to a stronger currency, but this was not (yet) the case last Friday. Both factors make the carry trade less attractive and, in extreme cases, even loss-making. In that scenario, investors are forced to reduce their positions, which can lead to the forced sale of equities, bonds, and other assets worldwide.

Yen/dollar carry trade index

The USD/JPY carry trade index shows the total return of a strategy that borrows yen (at the low Japanese interest rate) and invests in dollars (at the higher US interest rate). The return consists of the interest rate differential plus the USD/JPY exchange rate movement — a rising dollar adds to the return, while a falling dollar eats into it. In recent years, this has yielded double-digit returns due to the high interest rate differential and the weak yen, but sudden yen strength can quickly lead to losses as positions are unwound.

Historical precedents

History teaches us how painful such a settlement can be. Large yen carry unwinds contributed to sharp market declines in 1998, 2007, 2016, and 2021—the most recent example occurred in the summer of 2024. In August 2024, a combination of weak US labour market data and BOJ tightening created a perfect storm. The Nikkei 225 experienced its biggest one-day decline since 1987, while the S&P 500 lost more than 6% in three days. The VIX shot up.

Such market movements are usually short-lived, and the BOJ has carefully communicated its recent move. But the risk of a new carry trade crisis has not disappeared. On the contrary, the yen is once again approaching levels that forced the Japanese Ministry of Finance to intervene in the summer of 2024. If inflation in Japan proves more persistent than expected, or if the BOJ is forced to tighten policy more quickly, a sharp yen appreciation could trigger widespread deleveraging.

Japan’s policy rate and the carry trade

Bitcoin typically reacts negatively to Japanese interest rate hikes because the yen is an important financing currency for the global carry trade, in which investors borrow cheaply in yen to invest in higher-yielding assets, including risky investments such as crypto. When the Bank of Japan raises interest rates, the carry trade becomes less attractive and is partially unwound: the yen appreciates, investors have to liquidate positions to meet their yen obligations, and overall risk appetite declines. Bitcoin, as a distinctly risk-on asset with no cash flows or intrinsic value, is particularly sensitive to shifts in global liquidity conditions and thus serves as a barometer of sentiment toward speculative investments. The latest interest rate hike had already been priced in for months, whereas the previous one came as a much greater surprise.

Bitcoin price in dollars, Policy interest rate, Japan

The return of Japanese capital

A second dynamic is at play. For decades, Japanese pension funds, insurers, and private investors have sent their capital around the world in search of returns that could not be found at home. Now that domestic returns are rising, staying at home is becoming relatively more attractive.

If Japanese investors begin to reduce their foreign positions and repatriate capital, the consequences will be significant. It could put pressure on the dollar and the euro, depress share prices, and drive up bond yields, including in the United States.

For the time being, there is little sign of this happening. In the first eleven months of this year, Japanese investors bought a net total of 102 billion dollars’ worth of foreign securities, a multiple of the 4.4 billion in the whole of 2024. The weak yen still makes foreign assets attractive.

Ten-year interest rate in Japan

Political pressure and economic reality

The BOJ does not operate in a vacuum. Prime Minister Sanae Takaichi, who took office in October, based her economic programme “Sanaenomics” or Abenomics 2.0 on ultra-low monetary policy, a weak yen and, yes, more government spending. When the bond markets rebelled last month and sent yields to 18-year highs, there was already talk of a “Japanese Liz Truss moment”. Takaichi backed down, and the way was clear for Friday’s interest rate decision.

Inflation in Japan

The temporary upturns in Japanese inflation in recent decades were primarily due to VAT increases in 1997, 2014, and 2019, with the tax rate increases directly affecting consumer prices without any underlying demand-driven inflation. Once the base effect disappeared from the figures after twelve months, inflation fell back to the structurally low level that has characterised Japan for decades. Only this time it is different. Incidentally, US import tariffs can also be regarded as a “one-off” VAT increase with probably the same effect on US inflation.

Most Japan experts now recognise that a quarter-century of zero interest rates has done more harm than good. Instead of reviving animal spirits, free money has removed the urgency to reform: reducing bureaucracy, making labour markets more flexible, building a start-up ecosystem, increasing productivity, and closing the gender pay gap. Japanese companies had no incentive to restructure or innovate.

Tankan report

The Tankan report is the Bank of Japan’s most important economic survey, which gauges the mood among Japanese companies every quarter. The report contains a diffusion index in which companies indicate whether current conditions are favourable, neutral or unfavourable — a positive balance indicates optimism, a negative balance indicates pessimism. The most closely watched indicator is the index for large manufacturing companies, which serves as a leading indicator for the Japanese economy and thus also influences the central bank’s monetary policy.

Improved corporate governance in recent years has pushed the Nikkei to record highs. However, there is still no Japanese response to Chinese successes such as BYD or DeepSeek, nor is there a clear plan to catch up in the semiconductor race. And Sanaenomics has little to say about increasing Japan’s competitiveness — but a lot about continuing Japan’s role as a global cash machine.

Euro versus Japanese Yen

Japan is no longer the stable source of cheap capital it has been for decades. The carry trade that generated such high returns may well become a source of instability. Is the yen a safe haven? That mechanism could backfire when rising Japanese interest rates force carry traders to liquidate their positions. And the Japanese capital that has financed the rest of the world for years may slowly return home.

In a world where geopolitical tensions are rising, Trump’s trade war is sowing uncertainty and central banks are pursuing divergent policies, Japan’s normalisation is a factor to keep a close eye on. The era of free Japanese money is coming to an end.