Unlike the past, where economics dictated a strong yen despite loose policy, markets are now driven by politics. The Japanese government is allowing the yen to devalue to manage its debt, even as interest rates rise. This weakens the yen, strengthens the dollar, and could fuel a US equity boom via carry trades.

The upcoming Bank of Japan meeting is the most critical central bank event, with implications beyond FX markets. A hawkish surprise could create a volatility event in Japan's long-end yield curve, which could easily reverberate across global rates markets, impacting carry trades and broader market stability.

The Japanese Yen's persistent weakness is driven by the Bank of Japan's implicit choice to prioritize domestic financial stability, specifically in the government bond market, over the currency's value. This means that despite threats, FX intervention is a secondary tool, and the BOJ will allow the yen to "free float relatively more" to avoid bond market disruption.

In a stark regional divergence, Japan is tightening its monetary policy while its Asian peers are easing. The Bank of Japan has raised rates to a 30-year high, and its government bond yields have surpassed China's. This counter-cyclical stance makes Japan a significant outlier in the Asia-Pacific economic landscape.

A surprisingly hawkish BOJ tone, with dissents for a rate hike, bolstered its policy normalization credibility. This stemmed bearish sentiment at the long end of the JGB curve, shifting rate hike pressure to the front end and creating a bias for the curve to flatten.

A new market dynamic has emerged where Fed rate cuts cause long-term bond yields to rise, breaking historical patterns. This anomaly is driven by investor concerns over fiscal imbalances and high national debt, meaning monetary easing no longer has its traditional effect on the back end of the yield curve.

A critical but overlooked risk for the U.S. credit market is rising interest rates in Japan. Japanese banks are major buyers of AAA-rated Collateralized Loan Obligations (CLOs). If domestic yields become more attractive, they may pull back, removing a significant source of demand that underpins the entire leveraged loan ecosystem.

The recent flattening of Japan's yield curve masks underlying structural weakness in the superlong-end bond market. Reduced purchases by the Bank of Japan will keep net supply high, creating a challenging supply-demand dynamic that domestic investors alone may struggle to absorb, even if the Ministry of Finance cuts issuance.

Because Japan is the largest foreign holder of US debt, instability in its domestic bond market has a direct impact on American consumers. If Japanese bond yields rise, Japanese investors will sell their US treasuries, causing US interest rates to spike and increasing borrowing costs for mortgages and auto loans.