One week / one topic: The Japan trilemma

What happened?

Something is rotten in the state of Japan.

It is not a coincidence that all main local asset classes have recently posted extreme outcomes.

Japanese equities – taking the Nikkei 225 index as a representation of local stocks – returned 37% over the last three months, achieving their best quarterly return ever.

Japanese government bonds (JGBs) continue to suffer, with yields now reaching levels last seen in the 1990s amidst a prolonged multi-year upward move.

Finally, the Japanese Yen is at its weakest vs the US Dollar since 1986 – despite well-telegraphed threats of currency intervention. (Or perhaps, because of?)

A likely interpretation is that markets perceive Japanese policymakers to be stuck in a very difficult trilemma.

Tokyo can raise rates, coordinate intervention, or tolerate a weaker currency – while at the same time the current government has just received a clear electoral mandate for more fiscal stimulus, and the country’s manufacturing prowess (plus weak currency) keeps things hot.

Faced with this difficult choice, investors appear to believe that, at least for now, tolerating a weaker Yen is the path of least resistance.

But it this justified? And if so, what does it mean for the overall investment picture?

Our observations

• Fundamentals: The currency does indeed seem to be the pressure valve here to release pressures accumulated elsewhere in the system.

  The Yen’s weakness persists despite verbal warnings, a legacy of currency interventions and higher rates from the Bank of Japan.

• Price action: As highlighted above, recent price action across Japanese assets truly stands out as historic.

  Yes, many have failed to profit from previous extreme levels in Japan… but the market is asking questions that will soon need to be answered.

• Investor beliefs: Japan remains structurally different, and its uniqueness has provided alibis for investors to stay away for decades – bar the occasional tourist traps that have surfaced on Bloomberg screens from time to time.

  Is this time different?

So what?

Looking at the trilemma in more detail, you can immediately see why this is so difficult to square up.

Want to raise rates more aggressively?

You might engender support for the Yen but also risk tightening into a highly indebted economy (I know) and risk further unsettling the JGB market.

How about coordinated intervention?

Again – you might marginally mitigate Yen weakness – but prior interventions have achieved little, especially as of late.

Finally, you can accept a weaker yen – which is what seems to have happened as of late.

This would keep helping exporters and equities, but you’d then continue to import inflation and add to political pressures which have already been boiling higher for years.

The key portfolio question is therefore not simply whether Japan is attractive or not.

It is: which Japan exposure do we want to own?

For now, we have expressed a clear preference for equities since April 2025 – but we are increasingly intrigued by JGBs despite the looming threat of further volatility in the Yen.

Mood music: Imagine Dragons – Tokyo

By popular demand, here is the One week / One topic playlist

The information provided should not be considered a recommendation to purchase or sell any particular security.