A combination of rising inflation, higher government borrowing costs and shifting capital flows is putting pressure on global financial markets, with Japan’s monetary policy turning into an increasingly important factor for investors.
Bond markets have been at the centre of the latest sell-off, as persistent inflation and higher oil prices raise expectations that central banks will have less room to cut interest rates.
At the same time, Japan is moving further away from the ultra-loose monetary policies that defined its economy for decades, while China is consolidating hundreds of smaller banks as regulators seek to contain risks in a slowing economy.
The developments are unfolding against a backdrop of growing concerns over government debt in Europe and the US, raising questions about whether higher borrowing costs could spread across global markets.
Japan’s inflation changes the global picture
After decades of battling deflation, Japan is now confronting sustained price increases.
Tokyo’s core consumer prices rose 2.7% year on year in September, up from 1.8% in August and above economists’ expectations. The measure also exceeded the Bank of Japan’s 2% inflation target.
The broader underlying inflation measure, which excludes both fresh food and fuel, accelerated from 2% to 3%. Price increases have spread beyond energy, affecting food, everyday goods and electronics, while services inflation reached 2.3%, partly reflecting higher labour costs.
The figures are reinforcing expectations that the Bank of Japan will continue moving away from its long-standing ultra-loose monetary policy.
Japan’s benchmark interest rate reached 1.25% in September, its highest level in more than three decades, while the government has signalled that the economy has moved beyond its prolonged period of deflation.
The shift is already visible in the government bond market. Japan’s 10-year government bond yield climbed above 3.1%, reaching its highest level in decades.
For global investors, however, the significance of Japan goes far beyond domestic borrowing costs.
Japanese banks, insurers and pension funds have historically invested heavily in US Treasuries and European government bonds because domestic yields were extremely low. As Japanese bond yields rise, those overseas assets become less attractive, particularly once the cost of hedging against currency movements is taken into account.
Japanese investors had sold around ¥3tn, or roughly $19bn, of foreign securities by late August, the largest net amount of sales over the same period since 2022.
That does not yet amount to a wholesale repatriation of Japanese capital. But even a reduction in purchases from one of the world’s largest pools of institutional savings could have consequences for international bond markets at a time when governments are issuing large amounts of new debt.
Bond yields rise across the major economies
The pressure has already been visible in the US and Europe.
The US 10-year Treasury yield climbed to 5.34% during the week, while the 30-year yield reached 5.69%, with both touching their highest levels since 2002 before easing somewhat.
Higher Treasury yields have strengthened the dollar, while concerns surrounding European public finances have added pressure to the euro.
Gold has also been hit by the rise in bond yields and stronger demand for the dollar, with the price falling more than 3% over the week.
Oil prices have added another layer of uncertainty. Brent crude rose around 3.5% over the week to about $102 a barrel, despite falling on Friday, as geopolitical risks continued to influence the market.
The prospect of additional oil supplies has offered some relief. G7 countries have agreed to release a combined 100 million barrels of diesel and other petroleum reserves over four months, coordinated by the International Energy Agency.
But higher energy costs are still feeding inflation concerns and making it more difficult for central banks to ease monetary policy.
In the US, September’s non-farm payrolls increased by only 29,000, below expectations, while unemployment rose to 4.2%. The weaker labour market data reduced expectations of another Federal Reserve rate increase.
Core personal consumption expenditure inflation, the Fed’s preferred underlying price measure, rose 3% annually in August.
The combination of relatively weak employment and persistent inflation leaves investors facing an uncertain path for US monetary policy.
France emerges as Europe’s main pressure point
Europe is facing its own bond-market problems, with France increasingly at the centre of investor concerns.
French 10-year government bond yields approached 5% in early October, exceeding the yield on Italy’s equivalent debt. The spread between French and German 10-year bonds also widened sharply, reaching levels associated with the European debt crisis.
France’s difficulties reflect a combination of high public debt, a large budget deficit, weak growth and political uncertainty over efforts to reduce government spending and increase revenues.
French public debt is around 119% of GDP, while the budget deficit is expected to remain above 5% of GDP this year.
The approaching 2027 presidential election is adding another layer of uncertainty for investors as they assess the country’s future fiscal policy.
The change in the relative risk perception of France and Italy has been particularly striking. For decades, French government debt traded at significantly lower yields than Italian debt. That relationship has increasingly narrowed as investors have rewarded Italy’s improvement in its budget position while demanding a larger premium from France.
But Italy has not been completely insulated.
The spread between Italian and German 10-year bonds rose as high as 131 basis points during the week before closing at around 115 points. Yields also increased in Greece, Spain, Portugal and Belgium.
So far, investors appear to be distinguishing between France’s fiscal problems and the finances of other eurozone economies. A broader sell-off would become more concerning if that distinction disappeared.
The European Central Bank has a tool designed to address disorderly and unjustified market pressure, known as the Transmission Protection Instrument. But its use is not automatic and would depend on factors including debt sustainability and compliance with European fiscal rules.
China’s smaller banks come under pressure
While Japan is changing the direction of monetary policy, China is trying to strengthen its financial system by reducing the number of banks.
More than 670 banking entities were closed last year, according to official data from China’s National Financial Regulatory Administration. Almost all were rural lenders.
The closures have reduced the number of banking entities to 3,139, down 23% in four years, according to Fitch.
The consolidation reflects concerns about the health of smaller banks as China’s economy slows and the prolonged property downturn continues to weigh on demand for credit and bank profitability.
Smaller rural and city-level lenders account for more than a quarter of China’s banking assets. Fitch has described them as the weakest part of the country’s banking system, citing poor asset quality, low capitalisation and governance problems, particularly in less-developed regions.
The authorities have increasingly pushed weaker institutions towards mergers or absorption by larger banks in an effort to reduce the risk of liquidity problems.
In July, authorities in Wuhan took control of struggling Z-Bank, marking the first takeover of its kind since the 2019 intervention at Baoshang Bank in Inner Mongolia.
Z-Bank, which had assets of around Rmb124bn at the end of 2024, was subsequently absorbed by Wuhan-based Hankou Bank.
China’s banking sector is also dealing with the consequences of lower interest rates and deflationary pressure. Net interest margins have narrowed, making smaller lenders particularly vulnerable.
Authorities have responded with capital injections into some of the country’s largest banks. The government has also introduced measures aimed at supporting the wider economy and stabilising the property market.
Three different problems, one global bond market
The developments in Japan, China and Europe are different in nature, but they are increasingly connected through global financial markets.
Japan’s move away from ultra-low interest rates could reduce the incentive for Japanese investors to hold foreign bonds. At the same time, governments in the US and Europe are issuing large amounts of debt, forcing them to compete for capital at a time when investors are demanding higher returns.
China, meanwhile, is attempting to contain weaknesses in its banking sector before they become broader financial problems.
And in Europe, investors are testing whether governments with high debt and large deficits can maintain market confidence as borrowing costs rise.
The result is a more challenging environment for bond markets than the one investors became accustomed to during the years of near-zero interest rates.
The next test will come from economic data and central-bank decisions. Markets will closely follow US services activity, trade data and Federal Reserve minutes next week, alongside European inflation and economic figures and fresh Japanese data.
For investors, the central question is no longer simply whether inflation will fall. It is whether the world’s major economies can finance their growing debt loads without triggering a much broader repricing of government bonds.
So far, the pressure remains uneven. But the combination of higher Japanese yields, fragile European public finances, expensive US borrowing and vulnerabilities among China’s smaller banks is changing the landscape of global finance.
Be First to Comment