Bank of Japan's rate hike triggers a global financial domino effect — how will the domino effect unfold

The recent interest rate hike decision by the Bank of Japan is triggering a series of global financial chain reactions. This is not just a domestic monetary policy adjustment but a critical moment affecting the global financial system. The first substantial increase in interest rates in thirty years is pulling on the “pin” that could trigger systemic risk.

When the Bank of Japan raises its policy interest rate, the seemingly simple numerical change conceals underlying structural risks. Japan’s government debt has reached approximately $10 trillion, and in the context of rising interest rates, debt servicing costs will increase exponentially. Higher yields mean that future government fiscal pressures will surge, squeezing Japan’s economic growth potential. From a fiscal sustainability perspective, Japan faces three options: sovereign default, debt restructuring, or inflationary pressures. These are mathematical dilemmas that no modern economy can avoid.

Japanese Asset Outflows and the Global Liquidity Vacuum

Japan has accumulated a massive amount of foreign investments over the years, including over $1 trillion in U.S. Treasuries and several hundred billion dollars in global stocks and bonds. These investments made sense in an era when domestic interest rates were near zero—domestic returns were extremely low, making foreign investments a necessity. But when Japan’s yields rise domestically, the situation fundamentally changes.

Japanese investors face a new arithmetic problem: domestic bonds now offer real yields, while U.S. Treasuries, after considering exchange rate risks, have effectively negative returns. This disparity is enough to trigger capital reflows. Even a few hundred billion dollars reallocating back to Japan can create a liquidity gap in the global markets. This gap is not mild—it is systemic.

Risk Cascades Triggered by Arbitrage Liquidation

The real ticking time bomb lies in yen arbitrage trading. Over the past decade, global investors borrowed yen at extremely low costs and allocated funds into global risk assets—stocks, cryptocurrencies, emerging market bonds. This market exceeds $1 trillion and relies on the assumption that the yen remains a “cheap currency.”

As the Bank of Japan continues to raise interest rates, the yen appreciates, and the economics of arbitrage trading vanish. More importantly, when the yen appreciates beyond a certain point, investors with yen-denominated loans face margin calls. Forced liquidations will lead to:

• Large-scale sell-offs in global stock markets
• Liquidity drying up in emerging market assets
• Rapid declines in cryptocurrency prices
• Correlation among all risk assets soaring toward near-perfect positive correlation

In simple terms, everything will be sold simultaneously. This is not a risk that diversification can solve—it’s a systemic shockwave.

Federal Reserve Policy Space and Rising Global Financing Costs

Meanwhile, U.S. Treasury yields are under pressure. When Japan massively reduces its holdings of U.S. Treasuries, the U.S. government’s borrowing costs will rise accordingly. This makes borrowing more expensive for the U.S. government, directly threatening fiscal sustainability. The narrowing yield spread between the U.S. and Japan weakens the interest rate advantage that previously supported the dollar.

Central Bank Dilemmas

The Bank of Japan is caught in a difficult dilemma. Continuing to raise rates could further exacerbate the liquidation of arbitrage trades, but halting rate hikes would fail to address domestic inflation pressures. Simple monetary expansion is also not feasible—amidst rising inflation, continued large-scale money printing would only weaken the yen, increase import costs, and push domestic prices higher.

This impasse reveals a fundamental reality: when a country’s financial system has long relied on extreme easing policies, a sudden normalization process will inevitably shake the entire ecosystem. Japan will not bear these shocks alone—the global financial markets are deeply interconnected, and every decision by the Bank of Japan is pulling on the pin connecting risk assets worldwide. The next move, whether to hike rates or hold steady, could trigger unpredictable market chain reactions.