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Market Outlook

JAPAN HAS A CHOICE TO MAKE: RATES OR JPY

ADMIN || 21st January 2026

Japan’s policy framework is coming under renewed strain, with rising JGB volatility and a weak yen sharpening a trade-off that markets believe authorities can no longer avoid.

The latest selloff was led by the super-long end although the 40-year bond rebounded on Wednesday after Finance Minister Katayama called for calm among market participants. The catalyst for the recent rout has largely been self-inflicted: Prime Minister Sanae Takaichi’s pitch for a sales tax cut on food was seen as implying additional bond issuance, despite official efforts to downplay risks. A mixed 20-year auction added to the unease, reinforcing the sense that confidence at the long end has become fragile.

At the same time, the BOJ is still allowing JGBs to roll off its balance sheet and, while it will slow the pace of purchase reductions from April, the direction of travel remains one of gradually reduced support. This is where the policy trade-off becomes acute. Defending the bond market would require the BOJ to step back in and reassert control through heavier purchases or clearer yield backstops, bringing back curve control shortly after it was abandoned.

But that approach reinforces deeply negative and unattractive real yields, ultimately exacerbating yen weakness. Defending the currency, by contrast, implies tolerating higher front-end yields to improve rate support for the yen, a path that risks further bond volatility. Also let’s not forget the temporary impact of intervention, on top of the exorbitant cost.

As pressures build, policymakers will ultimately be forced to prioritize one objective, particularly if yen depreciation becomes politically intolerable or if bond-market dysfunction threatens financial stability. Japanese authorities are finding it painfully difficult to pursue both objectives simultaneously.

Markets are now on intervention watch, but it’s still far from base case. 1m and 3m vols have ticked higher of late but are sitting near the bottom end of one-year ranges. That’s a market cognizant of potential risks, but not one rushing to price in concrete action. USD/JPY 1m risk reversals are skewing lower, indicating an increase in yen-call demand. With riskies shown inverted on the chart, the move suggests that rising near-term volatility is increasingly coinciding with speculative appetite for USD/JPY downside.

Absent an external risk shock that eases global rate pressure, authorities may soon face a painful choice: Stabilize the bond market and live with a weaker currency or prioritize the yen and accept higher JGB yields.

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