Japanese stocks have been one of the standout performers in global markets this year, with the benchmark index hovering near record territory even as the country's central bank finally begins to raise interest rates

For much of the past three decades, the Japanese stock market carried a reputation as a place where dreams went to fade, forever haunted by the memory of a spectacular bubble that burst back in the early nineteen nineties. How times have changed. This year, Japanese equities have emerged as one of the genuine star performers on the entire global stage, staging a remarkable comeback that has caught the attention of investors right around the world and rewritten a long and painful chapter of financial history.

A standout year for Japanese stocks

The headline numbers tell a story of extraordinary strength that few would have predicted only a few years ago. The country's benchmark index recently stood at around sixty six thousand points, having climbed by roughly forty nine percent over the course of the preceding twelve months. That kind of annual gain would be impressive for any market, but it is all the more striking for an index that spent so many long years languishing well below its historic peaks and testing the patience of investors.

Even more remarkable is just how close the market now sits to uncharted territory. Earlier in the year, back in June, the index surged all the way to an all time high of around seventy three thousand points, finally surpassing records that had stood unbroken for a generation. Although it has eased back somewhat since that giddy peak, the market remains within touching distance of those historic levels, keeping the mood among investors decidedly upbeat and optimistic.

The Bank of Japan lifts rates

What makes this rally particularly fascinating is that it is unfolding at the very same moment that the country's central bank is embarking on a historic shift in its approach. In September the Bank of Japan raised its benchmark interest rate to one and a quarter percent, up from one percent previously, continuing its careful retreat from the era of ultra cheap money that defined the Japanese economy for so long. It marks another cautious step into a genuinely new monetary landscape.

Perhaps counterintuitively, the market actually responded to this tightening of policy with a good deal of relief rather than alarm. Two members of the policy board dissented from the decision, and investors ultimately judged the overall tone of the announcement to be somewhat less aggressive than many had feared beforehand. This reassurance helped to soothe nerves and allowed the underlying enthusiasm for Japanese shares to continue driving prices comfortably higher.

Bond yields climb higher

The shift in interest rate policy has naturally rippled through into the wider world of Japanese finance, most notably in the government bond market. The yield on the country's ten year government debt recently climbed to around three percent, a level not seen for a very long time and a world away from the near zero and even negative yields that were once commonplace across the Japanese financial system for many years on end.

Rising bond yields can sometimes act as a drag on stock markets, since they offer investors a more attractive and safer alternative to shares. In this case, however, the strength of corporate earnings and the broader momentum behind the market have so far proven more than powerful enough to offset any such headwinds. It is a delicate balancing act, and one that market watchers will be observing very closely in the months that lie ahead.

Banks and chipmakers lead the charge

Not all corners of the market have shared equally in the recent gains, with a couple of sectors doing much of the heavy lifting. Banks and other financial companies have been among the biggest winners, and for good reason, since higher interest rates generally allow lenders to earn wider margins on the money they lend out. After years of squeezed profitability in a low rate world, the changing environment has breathed fresh life into the entire financial sector.

Alongside the banks, the technology sector and semiconductor companies in particular have been powering ahead, riding the global wave of demand for advanced computing chips. Japan is home to a number of important firms that supply the machinery and materials essential to chip production, and these companies have benefited enormously from the worldwide boom. Together, these two very different sectors have provided the twin engines behind much of the market's recent climb.

The weaker yen factor

Another crucial ingredient in this success story has been the relative weakness of the Japanese currency against its major rivals. A softer yen is a considerable boon for the country's many large exporters, from carmakers to electronics giants, because it makes their goods cheaper and more competitive in overseas markets. It also flatters their earnings when profits made abroad are converted back into the home currency, giving reported results an extra lift.

This currency effect is something of a double edged sword, however, and not everyone benefits equally from it. While exporters cheer a weaker yen, it also pushes up the cost of imported goods, from energy to food, which can squeeze household budgets and stoke inflation at home. Managing this delicate trade off between a competitive currency and the cost of living is one of the many challenges facing policymakers as they navigate this new chapter.

What lies ahead for investors

Looking to the future, the big question is whether this powerful rally still has room to run or whether it is approaching its natural limits. Much will depend on the continued health of corporate profits, the future path of interest rates, and the ever unpredictable movements of the currency. With the record high so tantalisingly within reach, many investors are watching keenly to see whether the index can muster the strength to break decisively into new all time territory.

As always in the world of investing, a healthy dose of caution remains wise even amid all the excitement and optimism. Markets that have risen as far and as fast as this one can be vulnerable to sudden bouts of volatility should sentiment shift. Nevertheless, the transformation of the Japanese market from a byword for stagnation into a global leader represents a genuinely remarkable story, and one that few observers could have imagined even a handful of years ago.