BOJ Policy Normalization

Overall Assessment

The BOJ's historic normalization cycle -- four hikes from -0.

10% to 0.75% over 21 months, the most aggressive tightening in three decades -- is transmitting through the Japanese and global financial system in a bifurcated pattern that creates a deceptive sense of calm. On the surface, the transition appears remarkably orderly: global financial conditions remain loose (NFCI -0.568, loosening further), credit spreads are below median and compressing, the JGB market has absorbed 87 basis points of yield increase without dysfunction, and the speculative carry trade has fully unwound from CFTC futures without triggering an August 2024-style cascade. Financial stress is assessed as LOW and credit availability as STABLE. By conventional measures, BOJ normalization is proceeding exactly as planned. Beneath this orderly surface, however, structural pressures are building across multiple channels simultaneously. The hedging cost trap has activated for the first time in over two decades -- Japanese investors now earn 68 basis points less on hedged US Treasuries than on domestic JGBs, reversing the incentive structure that made Japan the world's largest foreign holder of US Treasuries. The US-Japan policy rate differential has compressed 120 basis points in 12 months to 289 basis points, with forward curves pricing continued narrowing to 175-200 basis points by year-end. The trade-weighted dollar has weakened 7.6% over 12 months, and the unprecedented US Treasury rate checks on USD/JPY signal official concern about yen misalignment. Each of these developments represents a slow-moving but structurally irreversible shift in the plumbing of global fixed-income markets. The central tension in this analysis is between the orderly present and the building pressure for the future. Financial conditions are loose precisely because the BOJ's real policy rate remains deeply negative at -1.85%, global risk appetite is strong, and the normalization has been deliberately gradual. But the system's capacity to absorb each incremental tightening step is diminishing. The carry trade has already undergone a massive repositioning, but OTC institutional positions remain opaque. JGB yields are at multi-decade highs but managed; the Takaichi fiscal expansion could push them into stress territory. Markets are front-running BOJ policy by 3-6 months, but 10-16 months of cumulative rate hike transmission remains in the pipeline for the real economy. The BOJ is walking a narrowing path between maintaining normalization credibility and avoiding a non-linear stress event. The decisive near-term catalyst is the spring 2026 Shunto wage negotiation results, due mid-March just before the March 18-19 MPM. All six lenses independently identify Shunto as the highest-leverage data point: strong results (above 5%) would validate the wage-price virtuous cycle, embolden the BOJ to accelerate normalization, and intensify all spillover channels simultaneously. Weak results (below 3.5%) would challenge the entire normalization thesis and provide the BOJ with justification to slow the pace. The headline CPI drop to 1.5% -- while anticipated and driven by fading supply-side factors rather than demand weakness -- creates additional uncertainty around the BOJ board's conviction. The inflation regime is transitional: the cost-push phase has ended, but the demand-pull phase has not yet proven self-sustaining. Japan's escape from its 25-year deflationary equilibrium hangs in the balance. The most consequential global implication is the structural regime change in cross-border fixed-income flows. The hedging cost trap, combined with the gravitational pull of JGB yields at 2.24% on the 10-year, is beginning to reshape the marginal demand for US Treasuries and global sovereign bonds. This is not a cyclical adjustment but a potential regime shift comparable in significance to the end of quantitative easing. If the BOJ normalizes to 1.25-1.50% as some analysts project, the structural Japanese bid for foreign bonds -- a defining feature of global markets for decades -- may permanently diminish. The August 2024 carry unwind demonstrated that the transition from orderly to disorderly can happen in days; the current environment offers more buffer than August 2024 but less than the calm surface suggests.

Outcome Space

Each bar shows the probability range for a downstream outcome. Wider bars mean the outcome is more sensitive to the condition. The dot marks the current base-case estimate.