What has happened in the Japanese market recently?

The Japanese market is undergoing an important turning point, with a fundamental shift in market pricing logic. Following the overwhelming victory of the Liberal Democratic Party in the House of Representatives elections, the yield curve of the yen has flattened, inflation expectations have stabilized, and the yen has strengthened—typical responses of developed markets facing higher expected real interest rates.

On February 14, according to news from the Wind Trading Desk, Goldman Sachs pointed out in its latest research report that the market has begun to price in the possibility of Japan exiting its ultra-low real interest rate regime, rather than merely viewing it as an inflation shock. The core driving factor behind this change is that investors are assigning a higher probability weight to expectations of asset repatriation and exiting the ultra-low real interest rate regime.

However, there is significant uncertainty about whether this shift can be sustained. Goldman Sachs warned that if the Bank of Japan fails to deliver on the market's expectations for a more hawkish path, previous market dynamics may revert, leading to a weaker yen and increased volatility in long-term interest rates.

The report specifically noted that key risks are concentrated on the policy path of the Bank of Japan. If the Bank of Japan shows any dovish signs in accelerating interest rate hikes—especially considering the recent strength of the yen—it could likely catalyze a return to pre-election trading dynamics.

Fundamental Shift in Market Pricing Logic

According to the report, two weeks ago, Goldman Sachs' analysis team proposed a framework to understand the performance of Japanese government bonds and the yen under the current policy mix. At that time, the logic was that when policy rates are constrained, inflation rises, and fiscal policy is planned to expand, it is a reasonable market response for both bonds and currency to weaken simultaneously.

Goldman Sachs pointed out that after the elections, the market exhibited a completely different dynamic. Real interest rates rose slightly, while forward inflation expectations declined slightly. The stock market rose, accompanied by a flatter nominal yield curve and a stronger yen.

The bank believes that this cross-asset class response is clear and consistent, aligning with the typical correlation pattern of developed markets when actual inflation approaches target levels.

Data shows that since the second half of 2025, there has been a significant divergence in the trends of 2-year and 3-year forward real swap rates and inflation swap rates, with real interest rates steadily rising and inflation expectations stabilizing.

Asset Repatriation Expectations as Core Driving Force

Goldman Sachs believes that the key to the shift in market pricing logic lies in investors beginning to assign a higher probability weight to the transfer of portfolio liquidity and exiting the ultra-low real interest rate regime. Combined with market expectations for new fiscal measures, these market trends primarily align with pricing in the increased likelihood of asset repatriation for Japan's net international investment position.

The report stated that some investors interpreted recent comments from the finance minister as a signal supporting the repatriation of foreign assets.

Given Japan's strong net international investment position, utilizing overseas assets to fund new fiscal expansions, or shifts in private sector portfolio liquidity and foreign exchange hedging, could stabilize the yen and boost prices of other domestic assets.

It is noteworthy that recent market trends have significantly narrowed the gap with Goldman Sachs' model predictions. The actual level of the yield spread for Japanese government bonds from 10 years to 30 years has approached the model fit value, indicating that the market is indeed pricing in a different regime post-election

The Policy Path of the Bank of Japan Faces Challenges

Whether the current market dynamics can be sustained largely depends on whether Japan can truly exit the ultra-low real interest rate regime. Goldman Sachs points out that the institutional challenges and policy debates Japan faces may make this transition difficult or prolonged.

Goldman Sachs believes that if the recent strength of the yen continues, the Bank of Japan is likely to appear more calm, which could reignite pre-election dynamics, where a weaker yen is a key prerequisite for faster interest rate hikes.

Given the current pricing of the policy path and the market's exploration of the possibility of exiting the low real interest rate regime, if the Bank of Japan shows any dovish signs in accelerating the pace of interest rate hikes, it is likely to catalyze a return to pre-election trading dynamics.

In terms of the policy path, the market currently only finds a compelling risk-reward ratio in the March meeting, pricing in 7 basis points.

According to research reports, even if the risks of a weaker yen and a steeper long-end curve may re-emerge, this will not constitute Japan's inflation equilibrium. Goldman Sachs believes that without a decline in the inflation outlook, the volatility of rates around the midpoint of the yield curve (near the 5-year mark) is unlikely to decrease.

Data shows a significant correlation between the 5-year to 30-year swap spread and the volatility spread. As the 5-year to 30-year swap spread rises from about 0.8% at the beginning of 2024 to the current level, the implied volatility spread between the 30-year and 5-year has also significantly widened.

Goldman Sachs believes that this volatility pattern indicates a greater risk of the yen yield curve flattening over a longer period.

The research report notes that in the short term, during the information vacuum period in the coming weeks, the current market conditions may continue to persist. However, Goldman Sachs tends to believe that this "may come too quickly and too much." If the Bank of Japan takes advantage of the recent strength of the yen to maintain a more gradual interest rate hike path, a weaker yen and increased volatility in long-term rates may follow