Bond Watch: why this developed market is raising interest rates

After interest rates across developed economies reached multi-decade highs amid periods of monetary restrictiveness, many central banks are now well into monetary easing cycles.

In December, the Federal Reserve brought down the policy rate by 25 basis points (bps) to 3.5%-3.75%, while the Bank of England lowered rates by 25bps to 3.75% yesterday (18 December) following a slide in inflation figures.

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Elsewhere, the European Central Bank (ECB), arguably at the end of its cycle, held deposit rates at 2%. Bucking the trend is the Bank of Japan (BOJ). It concluded its two-day meeting today with an announced rate increase of 25bps to 0.75% as the country emerges from a decades-long period of ultra-low interest rates.

After years of deflationary pressure that have given way to above-target inflation, Japan’s inflation rate is showing signs of sustainability. Along with the less desirable energy and food price pressure, the annual Shunto pay negotiations notably yielded meaningful wage growth (nominal wage growth was long an area in which Japan was lacking), while business sentiment indicators, such as the Tankan economic survey, have shown improvement in commercial conditions.

Restrictive policy? Or just normalising?

While this second rate hike of 2025 brings the bank rate to 0.75% - a multi-decade high for the country - this would hardly be described as a “restrictive” level for the economy. Rather, the BOJ are looking to normalise monetary policy from their formerly ultra-loose stance of zero or negative rates.

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While Federal Reserve chair Jerome Powell noted last week that the Fed’s policy rate has reached a feasible estimate of the upper end of the neutral rate – where monetary policy neither stimulates nor restrains economic activity - the BOJ is aiming to approach their own neutral rate from below.

Fiscal concerns

The medium- to long-term fiscal implications for the Japanese government of increasing borrowing costs will not be lost on investors, especially given Japan’s status as having the highest debt-to-GDP ratio (over 200%) of all developed economies.

The days of Japan borrowing at minimal costs may be behind us, and this is particularly pertinent given the appointment of Prime Minister Sanae Takaichi - a protégé of the late Shinzo Abe’s stimulus-heavy Abenomics, now adapted under the banner of Sanaenomics.

If borrowing costs do continue up towards more normal levels from here, investors will be hoping that Takaichi’s aggressive fiscal expansion policy will see Japan’s economy outgrow the burden of increased interest expense, lest we see a deterioration in fiscal conditions.

Market implications

Given the anticipation of the now-confirmed upward move in interest rates, the appointment in October of a stimulus-friendly PM, and a relatively upbeat sentiment towards businesses in spite of the hurdle of US tariffs, Japanese bonds and equities’ total returns (in Japanese yen and sterling terms) have moved in opposite directions in 2025.

The TOPIX and Nikkei equity indices are touching all-time-highs, outperforming most developed markets in 2025. Meanwhile, Japanese government bond yields had been rising ahead of the BoJ decision (and have stayed elevated in the immediate aftermath), meaning bond prices have come down.

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The expected rate increase has manifested in currency markets. While there were some surges of strength for the yen vs GBP and the dollar in the run up to the today, Bank of Japan Governor Kazuo Ueda’s post-meeting comments haven’t been sufficiently hawkish to prevent the yen from continuing its persisting downward trend immediately post-decision.

In the medium to long term, commitment to further tightening from the BoJ could support the yen, which may see the differential in interest rates between the yen and the dollar eroding at both ends. This could, over time, diminish the age-old carry trade - borrowing in yen in order to invest in higher-yielding assets, e.g. US Treasuries – so there could be spillover into global markets.

Either way, the ongoing speculation surrounding the trajectory of Japanese monetary policy likely will continue yielding substantial yen volatility, which may lead investors to consider their currency exposure to and/or hedging strategies of their equity or fixed-income investments in Japanese assets.