Japanese government bond yields have surged dramatically over the past year. The yield on the benchmark 10-year bond has climbed from around 1% to approach the critical 3% level. The 30-year bond yield, having broken above 3% in January, has accelerated its ascent, surpassing the 4% mark. Concurrently, the stock market's prolonged period of seemingly ignoring rising interest rates appears to be ending. Concerns are mounting that Japan's monetary policy normalization may be shifting from a boon to a potential burden.
The reaction in the bond market was swift and severe. Shortly after the opening, the yield on the 10-year Japanese Government Bond (JGB) surged over 10 basis points to 2.8%, marking its highest level in approximately 29 and a half years, since October 1996. The 30-year JGB yield jumped nearly 20 basis points from the previous week's close to exceed 4.20%, a record high since its issuance in 1999. The 5-year JGB yield also reached a historical peak recently. By May 19, the Nikkei 225 index closed at 60,550.59, marking its fourth consecutive day of decline. On May 15 alone, the index plunged 1.99% (1,244.76 points) to 61,409.29, representing its most significant single-day drop in the current phase. As of Wednesday morning, the Nikkei 225 was down another 1.13%.
Atsushi Sato, General Manager of the Securities Investment Department at Fukoku Mutual Life Insurance, offered pointed commentary: "The rising interest rate trend is putting pressure on highly-valued AI-related stocks. It's not surprising that the market is becoming cautious about heavily indebted companies; future market selection may become more stringent."
The bond market is facing pressure from both internal and external factors. Externally, persistent geopolitical tensions have kept international oil prices elevated, stoking renewed global inflation fears. This has led to significant concurrent rises in bond yields across major economies like the United States, the United Kingdom, and Europe. The yield on the 10-year U.S. Treasury note recently rose above 4.60%, a near one-year high, directly exerting upward pressure on Japanese rates.
Internally, fiscal prospects are having a more direct and profound impact. Announcements regarding the potential compilation of a supplementary budget for fiscal year 2026 and reports of the government considering issuing new deficit-covering bonds have sharply heightened market concerns over increased bond supply. Keisuke Tsuruta, an analyst at Mitsubishi UFJ Morgan Stanley Securities, noted that worries over a widening fiscal deficit are pushing up the "fiscal risk premium," becoming a significant driver of rising yields. Since the current administration took office, its proactive fiscal stance has contributed to a cumulative increase of over 1 percentage point in both the 10-year and 30-year JGB yields.
For Japan, the 10-year yield reaching 2.8% is not just a multi-decade high; it signals the rapid approach of a critical psychological and technical threshold. Some institutions project long-term rates could reach 3% within the year, a level many analysts see as a realistic target for the latter half of the year.
Kiyoshi Ishigane, Executive Chief Fund Manager at Mitsubishi UFJ Asset Management, issued a stark warning. He estimates Japan's sustainable nominal growth rate to be around 2.5%. If long-term yields persistently exceed this level, "they will begin to impose a tangible burden on the real economy," with negative effects from higher borrowing costs and reduced demand gradually materializing. A recent government report showed that while nominal GDP grew at 4.2% for fiscal 2025, the ongoing sell-off in government bonds is steadily narrowing the gap between growth rates and long-term yields, directly eroding corporate profit margins.
The relationship between Japanese stocks and interest rates has undergone a dramatic shift. Initially, as rates rose from 1% to 2%, the Nikkei 225 faced little negative impact and even rose concurrently. The market logic was that inflation-driven rate hikes were backed by nominal GDP growth and corporate profit expansion. As long as profit growth outpaced the rise in funding costs, the stock market could absorb the shock.
However, as long-term yields approach or even surpass the sustainable nominal growth rate, the underlying logic is fundamentally changing. Sato highlighted another transmission path: rising rates eventually translate into higher interest expenses for companies. "It is no wonder investors are growing more cautious about highly leveraged firms," he added, "The market may become more selective in the future."
Evidence of this structural change is seen in the "fatal cross" between JGB yields and stock dividend yields. The dividend yield for the Topix index components is currently around 2.3%, while the 10-year JGB yield has surged above 2.75%—the widest gap since the Bank of Japan's policy tightening in 2007. "From the perspective of dividend yield and earnings yield, bonds are gradually becoming more attractive than stocks," said Hiroshi Namioka, Chief Strategist at T&D Asset Management. This inversion of equity and bond yields is a rare phenomenon in Japan's market over the past two decades, systematically undermining the foundational logic that "stocks are better than bonds."
Despite substantial year-to-date gains for Japanese equities, the quality of the rally is increasingly questioned. Ishigane pointed out, "Since April, chip-related stocks have surged significantly, showing signs of overheating, which in turn makes the market more sensitive to rising yields." Analysis shows that since late March, approximately 80% of the Nikkei 225's gains have been driven by its top ten contributors—primarily AI and semiconductor-related stocks like SoftBank Group and Kioxia Holdings. This concentration means the market's upward momentum relies heavily on a few high-valuation growth stocks, which are precisely the most sensitive to interest rate changes.
The sell-off on May 15 was led by AI and semiconductor shares. Sato explicitly stated that the rising rate trend directly pressures highly-valued AI-related stocks. Subsequent sessions saw continued weakness in semiconductor and wire & cable stocks, with profit-taking flows rotating into lower-valued sectors like banks, insurance, food, and retail.
The impact of rising rates shows significant divergence across sectors. Banking shares have shown relative resilience, with Mitsubishi UFJ Financial Group rising over 3% against the trend, as higher rates improve net interest margins and profitability for financial institutions. This very divergence, however, exposes how index-level "prosperity" may be masking broader pressure on individual stocks. Maki Sawada, an equity strategist at Nomura Securities, commented, "Investors reacted negatively to the decline in the three major U.S. stock indices and the rise in Japan's 10-year bond yield." On May 18, the Nikkei 225 fell over 1,000 points intraday before closing down 0.96%, with most of the Tokyo Stock Exchange's 33 industry sectors declining.
At this critical juncture with yields nearing 3%, some relatively optimistic voices remain in the market. Sohei Takeuchi, Senior Fund Manager at Sumitomo Mitsui DS Asset Management, believes stocks may retain their appeal as Japan enters a phase of nominal economic expansion driven by inflation. He judges that a large-scale shift from stocks to bonds is unlikely unless JGB yields rise to levels similar to U.S. Treasuries (implying a remaining gap of over 200 basis points). Hiroshi Watanabe, Head of Financial Market Research at Sony Financial Group, also suggested a sharp near-term correction in Japanese stocks is unlikely, as "it takes time for rising interest rates to negatively impact the macroeconomy and corporate profits."
The core logic of these views rests on the assumption that high nominal GDP growth—4.2% for fiscal 2025—can, in the short term, offset the pressure from rising rates on corporate profits. Recent profit improvements at several AI-related companies, including Kioxia Holdings, have reinforced perceptions of strong fundamentals.
However, this judgment hinges on two key assumptions: first, that nominal GDP growth can sustainably outpace long-term interest rates, and second, that the pace of rate increases is slow enough to allow companies time to adjust their balance sheets. Both assumptions are currently under challenge. On one hand, the speed of the rate increase has far exceeded expectations. Less than a year ago, the Bank of Japan's internal projections estimated yields would drift to only about 1.32% by March 2026; the current reality of 2.8% is more than double that forecast. On the other hand, persistently high oil prices pose ongoing cost pressures for Japan as a net importer, while geopolitical uncertainties amplify fiscal expansion pressures—together pushing the "race" between nominal growth and interest rates into an intense phase.
In essence, if the judgment that "it takes time for rising long-term rates to produce negative effects" is correct, it means that even if the market has not fully priced in this risk today, it does not mean the risk is absent. It is merely on the way, and possibly moving faster than the market anticipates.
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