‘Worse than Greece’: Japan’s bond vortex sends a global warning

It may have been the most closely watched bond auction in years. Japan’s sale of 40-year bonds on Wednesday didn’t, however, dispel the question marks investors have over not just Japanese bonds and Japan’s economy, but sovereign bonds around the world.

The weakest demand in nearly a year for 40-year government bonds followed an even more disconcerting auction of Japan’s 20-year bonds last week, where demand was at its weakest in a decade.

The imbalance between supply and demand for the bonds has sent their yields soaring, with the yield in the 20-year securities hitting a record high last week and the 40-year bond yields up a whole percentage point in only a week.

“Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece’s”: Japan’s Prime Minister Shigeru Ishiba.Credit: AP

The disturbing developments within the long end of Japan’s government debt market over the past week, which have created the steepest yield curve for government debt in the world, have caused the Bank of Japan to rethink its strategy.

It is contemplating reducing the supply of ultra-long-dated debt and issuing more short-term notes to adjust supply of the 20, 30 and 40-year bonds to the diminished demand.

It is tempting to see the developments within Japan’s bond market as something peculiar to Japan, which only recently emerged from decades of deflation and anaemic growth, with the country’s legacy of a debt-to-gross domestic product ratio of more than 260 per cent.

Japan’s circumstances are difficult, and made more so by Trump’s trade policies, which will hit Japan at a vulnerable moment.

Those debt levels, the recent re-emergence of inflation (something the BoJ sought to kindle throughout the lost decades), modestly positive (rather than negative) official interest rates and its aged population make Japan’s economic circumstances uniquely challenging. Its inflation rate, at 3.6 per cent, is the highest among advanced economies.

The rising yields in Japan are, however, similar to what’s happened in other markets for bonds with long durations this year, particularly in the US – and more particularly what’s occurred since Donald Trump’s April 2 “Liberation Day,” when he announced a US trade war against the rest of the world.

(A war whose future, after Wednesday’s ruling by the US Court of International Trade, is now uncertain).

And Japan’s bond market, the third-largest in the world, is connected to the rest of the financial world’s plumbing, especially with the US financial system.

For decades there has been a massive “carry trade,” where Japanese institutions and investors, and foreign hedge funds, have borrowed very cheaply in Japan to invest in higher-yielding US assets, including US bonds.

The macro picture suggests that bond investors have, relatively recently, started demanding a bigger premium for the risk of holding long-dated bonds, particularly the ultra-long maturities of some of the Japanese bonds on issue.

There’s a definite correlation between the April 2 announcement and the spike in Japanese and US bond yields, with Trump’s aggressive tariffs casting a pall over the global economic outlook and the outlook for America’s major trading partners, of which Japan is one.

America’s assault on global trade, along with some of the Trump administration’s other “America First” policies, has ignited a “Sell America” trade, which is being seen most obviously in the US bond market and the value of the US dollar, which has fallen 9.2 per cent against a basket of America’s trading partners so far this year, including 4 percentage points since April 2.

Assault on global trade: Donald Trump on “Liberation Day”.Credit: Getty Images

Some of the capital fleeing Trump’s America has headed to Japan, with a surge in foreign purchases of Japanese shares and bonds since April 2. Europe has experienced something similar.

More threatening and potentially destabilising for the US is the potential for the Japanese carry trade to unwind.

Japan is the biggest holder of US bonds, with investments of more than $US1.1 trillion ($1.7 trillion), along with significant holdings of other financial assets. Even Japanese households, faced for decades with negative short-term bond yields in their home market, have chased the higher returns available in the US.

Now, with domestic yields rising and the US dollar tumbling, the risk-reward equation for Japanese investors is rebalancing and, after factoring in the cost of hedging the currency exposures, is starting to shift towards their home market.

The US is in an analogous fiscal position to Japan, albeit that its government debt isn’t (yet?) at Japan’s stratospheric levels. Its debt to GDP ratio is around 100 per cent, with Trump’s “One, Big, Beautiful Bill Act” projected to add $US3.8 trillion or more to debt over the next decade and to raise that rate to about 118 per cent 2034.

The BoJ has been reducing its purchases of government debt - it owns about 52 per cent of that debt – as it has begun normalising its monetary policies. It has been reducing its bond purchases by 400 billion yen (about $4.3 billion) each quarter.

The US Federal Reserve has, similarly, been allowing its holdings of bonds to shrink by not reinvesting the proceeds as the bonds mature.

In both markets, that means the former major buyer of the bonds is gradually withdrawing a key source of demand and liquidity for bonds, even as their issuance continues to increase and, in the US, where there has been a focus on short-term debt issuance, the volume of maturing debt is surging.

In Japan, where life insurers and other institutions have been among the major non-government buyers, changed solvency requirements and heavy losses from existing holders are also diminishing demand. Four major insurers lost more than $90 billion on their bond holdings between them in the first quarter.

Less demand, coupled with greater supply, inevitably means higher yields and rising interest costs for already stretched government finances.

Japan’s Prime Minister, Shigeru Ishiba, under pressure to cut taxes to blunt the impact of the rise in interest rates, said last week that it was important to recognise the dangers of a society and economy with (high) interest rates.

“Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece’s,” he said, presumably a reference to the debt-inducted crisis Greece faced in 2009, when there was a serious risk that it would be forced from the European Union.

The US, of course, had its last remaining AAA credit rating withdrawn by Moody’s earlier this month because of its strained and deteriorating public finances.

With an inflation rate above the yields on its bonds, despite their recent spikes, real interest rates in Japan remain negative, which may help with management of government debt but could also deter buyers if they doubt the BoJ’s ability to bring inflation under control.

Growth isn’t going to help much. After Trump announced his tariffs – Japan faces the baseline 10 per cent tariff, a 24 per cent “reciprocal” tariff and the 25 per cent levy on its vehicle exports the US – the BoJ downgraded its outlook for economic growth this year from 1.1 per cent to 0.5 per cent and from 1 per cent to 0.7 per cent next year.

Japan’s circumstances are difficult, and made more so by Trump’s trade policies, which will hit Japan at a vulnerable moment.

America, however, has its own weaknesses – most of them, if not all, self-generated and then magnified by the Trump administration. Its vulnerability would be exacerbated if the higher bond yields rates in Japan suck capital away from the US bond market.

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