TOKYO—Japan’s two-month experiment with negative interest rates is producing some unexpected results.

Trading has withered in Japan’s money markets, where big banks and others usually park their excess cash hoping to receive some interest—despite predictions from the Bank of Japan that its latest easing of monetary policy would spark more activity. And there has been a rush in demand for Japanese government bonds even as many yields went below zero.

Instead of falling, the yen has surged to 18-month highs against the U.S. dollar.

Still, Japan’s central-bank governor, Haruhiko Kuroda, who was in New York Wednesday, said the Bank of Japan is ready to expand its bond-buying program and cut interest rates further into negative territory as it attempts to bolster economic growth. The BOJ “will not hesitate to take additional easing measures in terms of…quantity, quality and the interest rate if it is judged necessary,” he said.

Participants in the Japanese markets have less conviction than Mr. Kuroda. In interviews, they describe a banking and finance system that is increasingly scrambled by negative rates and their consequences.

“Every day is like being Alice in Wonderland,” said Tomohisa Fujiki, head of interest-rate strategy at BNP Paribas Securities Japan. “Interest-rate levels are having little effect on credit demand, the market function is declining. You can’t expect everything to go according to plan.”

Japan surprised markets in January when it set a minus—0.1% rate on some deposits that banks place at the central bank, effective from mid-February. Its move was designed to encourage banks to lend more, spurring higher spending and inflation. Yet that has not been the case so far.

Lower interest rates normally lead a country’s currency to depreciate, helping its exporters—a key aim of “Abenomics,” the package of stimulus measures brought in by Prime Minister Shinzo Abe.

Demand is coming from an unusual source: foreign investors, who in the past have largely stayed out of the low-yield market but have recently jumped in because of rising returns on Japanese-bond trades thanks to the cheaply funded yen.

Traders also have pushed up the yen believing Japan’s central bank can’t do much more to ease policy.

“There is no guarantee that lowering interest rates encourages corporate capital expenditures or expedites the shift of household financial assets from savings to investment,” said Nobuyuki Hirano, president of Mitsubishi UFJ Financial​Group​Inc., Japan’s biggest bank, on Thursday, adding the negative-interest policy had caused households and businesses to rein in spending amid growing uncertainty over the future.

One problem has been Japanese banks’ computer systems: The trade-confirmation system used by money-market brokers wasn’t fully updated for negative interest rates until over a month after the BOJ rate cut. Money-market trading volumes dropped to their lowest level since at least 2011 at the end of March, according to Japan’s Money Brokers Association, down to nearly a 10th of January’s levels.

Money markets allow banks and other financial institutions to lend and borrow money for a period of less than a year, often not backed by collateral. If fewer banks invest cash in short-term markets, it is harder for other banks to get short-term loans to finance their operations.

Japanese trust banks that manage cash on behalf of mutual and pension funds have in recent weeks been placing excess money on deposit at the BOJ rather than into overnight money markets, where it might now attract a negative interest rate.

“If the money market dries up, if there is an event like the Lehman crisis, there won’t be the infrastructure for banks to raise capital,” said Naomi Muguruma, strategist at Mitsubishi UFJ Morgan Stanley Securities. “It could cause interest rates to rise sharply.”

Placing money at the central bank also can attract a negative-interest-rate charge, if the amount of cash set aside in this way exceeds the trust bank’s quota. Starting on April 18, Mitsubishi UFJ Trust & Banking Corp. will start passing on that charge to mutual-fund managers and pension funds, levying a 0.1% and 0.06% fee respectively on excess cash that it used to invest in the money market. Another large institution, Sumitomo Mitsui Trust Bank Ltd., says it will implement similar fees.

Problems in the money markets have run counter to Mr. Kuroda’s expectations: last month he said that as market players get used to negative rates, money-market trading should increase. Mr. Kuroda predicted banks that had to pay a minus-0.1% interest rate on some of their reserves would want to lend out that money for a higher rate.

Instead, Japanese financial institutions have been searching overseas for higher returns, without a corresponding rise in investment at home. Japanese investors bought a total of ¥5.47 trillion ($50 billion) worth of foreign securities in March, up 11% from February, according to the finance ministry.

In turn, the amount foreign financial institutions can charge to lend greenbacks to Japanese investors has surged. The premium for a three-month contract to exchange yen for dollars is now at ¥0.298, almost twice what it was a year ago.

Foreign investors have been recycling the yen they get back into Japanese government bonds, traders say, even though yields on a range of these bonds have turned negative in recent weeks—meaning investors who buy them end up paying money to Japan’s government. But the fee foreign institutions can charge to lend dollars is now so high that it outweighs the cost of holding negative-yield-bearing bonds, which remain the safest place for investors to park their yen.

The upshot: an unusual bout of foreign interest in Japan’s government bonds, an often sleepy market where overseas investors have generally held under 10% of outstanding bonds. Net foreign buying of medium-term Japanese government bonds was double the 12-month average in February, the most recent month for which data are available.

ENLARGE

In all, foreigners bought a net ¥18.3 trillion worth of Japanese government bonds in February, according to the Japan Securities Dealers Association, up 16% from the month before. Overseas investors accounted for over one-quarter of all trading in short-term Japanese government bonds that month, and 15% of trading in medium-term bonds.

The strong desire among some Japanese investors for dollars hasn’t been enough to keep the yen down, however.

“There’s no rhyme or reason on why the yen would strengthen when interest rates are negative,” said Bart Wakabayashi, managing director at State Street Global Markets. “But the yen has now reasserted itself as a safe-haven currency on concerns about China and the global economy. And at the same time, doubts are emerging over the staying power of Abenomics.”