Ajay Rajadhyaksha is global chair of research at Barclays.
The Japanese government bond market was already having a bit of a springtime nightmare, but a poor auction of 20-year debt earlier this week has sent long-end yields soaring to their highest levels ever.
Here’s a long-term chart of the 30-year Japanese bond yield. As you can see, there’s been an almost parabolic rise in long-term interest rates, with seemingly no end in sight.
The 40-year Japanese bond now yields nearly 3.7 per cent, up a full percentage point just since the beginning of April. That hurts. If the duration of the bond is, say, 20 years, investors have lost almost 20 per cent in just a few weeks. In a high grade government bond. That sort of thing just isn’t supposed to happen in the developed markets; bonds are supposed to be the safe asset class.
The internals of the Japanese bond market look even more worrying. The 40-year is a “benchmark” bond — a frequently-quoted part of the bond curve. Spare a thought instead for the 35-year old JGB, the 40-year bond issued a few years ago. It now yields over 4.6 per cent — almost 1 per cent more than the “on-the-run” 40-year JGB!
The Japanese yield curve is upward sloping — in fact, the steepest yield curve in the developed world. That means longer maturity bonds should have higher yields. And yet, the 35-year JGB now yields over 100 bps more than the 40-year one, simply because it is less liquid and “off-the-run”. That kind of glitchy pricing is pretty stark evidence of the evaporating demand for longer-term Japanese debt.
Japan’s fiscal problems are well known, of course. The country has had a massive debt burden for many years. Its credit rating is three notches below the US even after the recent US downgrade. Prime minister Shigeru Ishiba called Japan’s fiscal position “worse than Greece’s” — presumably referring to the Greece of the European sovereign debt crisis (Greece is in OK shape right now). None of this is new.
But several things have changed recently.
First is inflation. Headline CPI in Japan is now 3.6 per cent, and has been above 2 per cent for over three years. That means that a 30-year bond yield at 3.15 per cent is still below inflation, or negative in real terms.
Second, Japanese insurers have virtually stopped purchasing very long-term bonds, to satisfy new economic solvency ratios introduced recently.
Third, long-term fiscal concerns are rising. The US is pressuring Japan to spend 3 per cent of GDP on defence (from the current 1.6 per cent). The ruling coalition is considering a supplementary budget, while the opposition is pushing for a consumption tax cut. No one seems to be talking about less spending and raising more tax revenues.
Perhaps the most important change is from the Bank of Japan. The central bank still owns a staggering 50 per cent-plus of the Japanese government bond market. But with deflation now in the rear view, the BoJ has started quantitative tightening — allowing its existing bond holdings to slowly hit the market. And as this one massive buyer has become a net seller, Japanese bond yields are normalising — aka rising.
So . . . what breaks this downtrend?
For one thing, the BoJ could jack up interest rates quicker. But at its last meeting the central bank surprised markets by being more dovish than expected, and the next one is in mid-June, over three weeks away. Japanese policymakers are not predisposed to intra-meeting moves. Doing so might actually panic markets.
The Ministry of Finance could reduce issuance of longer bonds, and increase the issuance of shorter bonds to ease pressure on longer rates. But the MoF did exactly that in April, without any success, and is also loath to take unscheduled action. The next chance for the MoF to adjust its issuance mix should be when the supplemental budget is presented, probably in the third quarter.
Quasi-governmental entities like Japan Post, Norinchukin, and GPIF together own over a trillion dollars of foreign bonds. The government could urge them to support the Japanese bond market. But that would likely involve selling their foreign bond holdings — most likely Treasuries — to buy JGBs. With Japan-US tariff negotiations under way, does Japan really want to be seen as the reason Treasury yields keep rising?
Which brings us to why US investors really should care about the JGB move. Duration is fungible across developed economies. If investors see JGBs or gilt yields rise sharply, they rush to sell duration in similar bond markets. What happens in Japan doesn’t stay in Japan.
And then there’s the risk that large allocators might start to change their ways. A portfolio manager sitting in Tokyo could ask himself “For decades, the BoJ kept bond yields depressed, which forced me to buy foreign bonds. But now JGB yields are finally at attractive levels as the BoJ backs off. Why am I still taking the currency risk in Treasuries when all my liabilities are in Yen? Maybe I should just buy JGBs. It’s time to come home!!”
Global bond markets are clearly paying attention. US Treasuries shrugged off the Moody’s downgrade, but since Tuesday the 30-year US Treasury yield has risen almost 20bp — the highest level since the 2008 crisis — to well over 5 per cent after dismal auction yesterday. As a result, US mortgage rates are back above 7 per cent.
There has been no data to speak of, and the tax bill that just passed the House contained no new surprises for the market. The main driver of the US bond move seems to be what is happening 7,000 miles away in Tokyo. In fact, the long end of pretty much every major bond market is getting caned in a broad-based duration crash.
Japan bulls will point out that the last few weeks are not a repudiation of Japan Inc — and they’re right. No one is fleeing the yen, and the Nikkei is still up for the year in dollar terms. The economic impact is limited by the fact that most Japanese debt — mortgages, corporate debt, etc — is issued in shorter bonds.
But . . . Japanese policymakers are now at serious risk of losing control of the long end of the Japanese yield curve, absent imminent and forceful intervention. And if that happens, it’s bad news for everyone.