Japan warns about stock market overheating and risks from foreign funds

The Bank of Japan (BOJ) warned this Thursday that the Japanese stock market is showing early signs of overheating, while alerting about the risks of a possible sharp correction stemming from trade uncertainty with the United States.

The Nikkei 225 index reached a new all-time high this week after the election of Sanae Takaichi as the country's prime minister, driven by her pro-fiscal stimulus stance.

The index has accumulated an increase of almost 26% in 2025, reflecting the strong investor appetite that is now concerning the central bank. Evolution of the Nikkei 225 in 2025. Source: Google Finance

Hedge funds and volatility in bonds

In its semiannual report on the financial system, the BOJ noted that the growing prominence of foreign hedge funds has increased leverage in the Japanese government bond market (JGB).

The entity warned that a rapid exit from positions could amplify volatility in asset prices, affecting a wide range of financial instruments.

Between April and May, the yields on very long-term bonds surged due to massive sell-offs following rumors of a large public spending package. Although yields stabilized afterwards, analysts warn that Takaichi's plans could reactivate selling pressure and further weaken the yen.

Overheating signals in stocks and real estate

The report included a heat map of financial imbalances, in which Japanese stocks were marked in red, while the other 13 indicators remained in green.

The central bank highlighted that financial institutions maintain significant exposure to equities, which increases the risk of a potential correction.

It also warned about the rise in real estate prices in Tokyo and other major cities, driven by investment demand, including foreign flows. Prices of new condominiums in the Tokyo metropolitan area increased by 20.4% year-on-year between April and September, according to the Real Estate Economic Institute.

Stability with nuances and prudent monetary policy

Despite the warnings, the BOJ stated that the financial system remains stable, with well-capitalized banks and solid financing to withstand different scenarios.

The entity raised its benchmark rate to 0.5% in January, after emerging from a decade of ultra-expansive policy, but Governor Kazuo Ueda remains cautious about the potential impact of U.S. tariffs on the Japanese economy.

According to a Reuters survey, most economists expect a new rate hike in the fourth quarter, possibly as soon as next week.