The Bank of Japan has issued a warning in a recent report, stating that potential unwinding activities by global hedge funds could rapidly spread to the Japanese government bond (JGB) trading market. This latest caution from the central bank indicates that the Japanese bond market is no longer just a local issue but a critical transmission point within the global liquidity chain. Should a global risk event trigger deleveraging or position liquidation by these funds, the next wave of impact may not be confined to Japan but could instead trigger synchronized and severe selling across global stock and bond markets.
In its semi-annual Financial System Report released on Tuesday, the Bank of Japan noted that the presence of overseas hedge funds "has been increasing in the Japanese bond market." The report emphasized the need to "carefully monitor the possibility that if foreign hedge funds unwind their positions globally during a stress event, the impact could spread to Japanese and global bond markets through channels such as a sudden drop in market liquidity."
According to an analysis of data from the Japan Securities Dealers Association, foreign investors accounted for approximately 60% of JGB trading volume last month. Their dominance is even more pronounced in the JGB futures market, where they represented 78% of trading volume in March. As shown in the accompanying chart, global leveraged hedge funds are increasingly dominating JGB trading.
The Bank of Japan also indicated that the scale of arbitrage trading by foreign hedge funds appears to have expanded, which could heighten the risk that overseas shocks will have a greater impact on Japanese and global financial markets. The report further highlighted the need to monitor the activities of directional hedge funds, as a significant correction in risk assets—such as popular global technology stocks closely linked to artificial intelligence—or a further escalation of geopolitical conflicts in the Middle East could trigger substantial selling pressure.
During a sharp decline in the Japanese bond market in January, the 10-year JGB yield surged nearly 20 basis points over two days. At that time, Wall Street analysts noted that the sell-off dragged global equity and bond markets into a more complex narrative concerning debt and interest rates. Additionally, recent warnings from the IMF indicate that rising oil prices and inflation resulting from Middle Eastern conflicts are tightening global financial conditions, potentially exerting sustained pressure on non-bank institutions, private credit, and AI-related borrowers.
The IMF has specifically emphasized that Middle Eastern geopolitical tensions have already pushed up global sovereign bond yields and could force leveraged hedge funds into large-scale asset sales. In essence, the Bank of Japan's latest warning serves as a reminder to markets: if leveraged funds trigger a sell-off in JGBs, the next shock may not be localized but could instead lead to simultaneous sharp declines in global stock and bond markets.
Therefore, if liquidity in the JGB market deteriorates suddenly, global bond and equity markets would face not merely a typical decline in risk appetite, but a triple resonance of "sharply rising yields, deleveraging, and compression in growth stock valuations." For global equity markets in particular, large-scale selling of JGB assets by overseas hedge funds could act as a "valuation compression mechanism for risk assets, transmitted through the yield curve and liquidity crises."
When hedge funds are forced to unwind positions on a large scale, either in Japan or globally, the first casualties are often not earnings expectations themselves, but rather high-valuation, long-duration assets that depend on loose financing conditions—particularly technology growth stocks, including those closely tied to AI, and other sectors where risk-appetite concentration is highest. The Bank of Japan even explicitly mentioned the need to monitor directional hedge funds, as adjustments in AI-related stock prices or an escalation of conflict involving Iran could act as potential triggers.
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