Japan's bond market turns nervous

Yields on 30-year Japanese government bonds (JGBs) rose to about 3.2 per cent, a sharp jolt for what has long been the calmest and most tightly managed government bond market in the world. The super-long end of the curve steepened fast as investors grew uneasy about fiscal populism at home and about how much further the central bank can help.

From control to retreat

For most of the past decade the Bank of Japan owned the yield curve. It capped ten-year yields under its yield-curve-control policy and bought so many bonds that it came to hold roughly half of all JGBs outstanding. In March 2024 it ended negative interest rates and dropped the yield cap, and in July last year it set out a plan to cut its monthly purchases step by step. The policy rate has since risen to 0.5 per cent. Each step has handed more of the price-setting back to private investors, who are proving less accommodating.

The strain was visible before this month. A 20-year auction in May drew weak demand, and the super-long end sold off hard in response. The Ministry of Finance answered by trimming its planned issuance of the longest bonds, and the Bank of Japan agreed in June to slow the pace of its taper from next spring. Those were modest fixes, and yields have climbed again regardless.

Handouts meet fewer buyers

Japan's political parties are competing ahead of national elections to offer voters handouts, utility subsidies and cuts to sales tax. That leaves the Ministry of Finance with more debt to issue just as the Bank of Japan pulls back from buying bonds. Domestic life insurers and pension funds used to take super-long JGBs almost whatever the return. Now they want a proper term premium for holding the paper while inflation stays sticky and government borrowing grows.

The upper-house election on 20 July sharpens the problem. The ruling Liberal Democratic Party has promised cash payments to households, while most opposition parties want to cut the consumption tax, which stands at 10 per cent. Gross public debt is already well over twice the size of the economy. Even a temporary tax cut would have to be financed with bonds, and the market is now telling the government what it will charge for them.

Earlier Japanese shocks

Japan has had bond scares before. In late 1998 yields jumped after the Trust Fund Bureau, then a large state buyer of JGBs, said it would stop buying, and in 2003 a sell-off driven by banks' risk models pushed yields sharply higher within weeks. Both episodes faded once official buyers returned. This time the official buyer is deliberately stepping back, and the inflation that would justify higher yields is real. Britain's gilt crisis of 2022 is the less comforting precedent: a government that promised unfunded tax cuts saw long yields spike until the central bank stepped in.

Trouble for Treasuries and Bunds

The sell-off matters well beyond Tokyo. For decades Japanese institutions were the biggest exporters of capital in the world, buying US Treasuries, European Bunds and Australian government bonds. With 3.2 per cent on offer at home, they have good reason to bring money back, and Western bond markets would lose their most dependable foreign buyer.

The calculation for a Japanese insurer is straightforward. A 30-year Treasury yields more, but once the cost of hedging the dollar back into yen is deducted, the gap narrows sharply or disappears. A 3.2 per cent yen return with no currency risk now compares well with a hedged foreign bond. Japan is the largest foreign holder of Treasuries, so even a slowdown in its purchases, let alone outright selling, removes a steady source of demand. A repatriation of this kind would also tend to strengthen the yen.

The unwinding of the yen carry trade last August, when the Nikkei suffered its worst day since 1987, showed how quickly Japanese flows can move global markets. That episode was driven by a surprise rate rise and a sudden yen rally. A slow shift in insurers' asset allocation is less dramatic but longer-lasting.

Winners and losers at home

Higher yields are not bad news for everyone in Japan. Life insurers and pension funds can finally reinvest new money at returns that match their long-dated promises, and savers holding cash will eventually earn something on it. The losers are holders of existing bonds, who face mark-to-market losses, and the government itself, whose interest bill rises as old low-coupon debt is refinanced. The Bank of Japan, sitting on a huge portfolio bought at tiny yields, now earns less on its assets than it pays on the reserves banks hold with it as rates rise.

The case against

The counterargument is that the Bank of Japan will not allow a disorderly market and still has the tools to buy bonds if needed. That is true, and a sharp spike would probably bring intervention. Intervention of that kind would mean reversing the normalisation the bank has spent two years pursuing, while inflation runs above its target. That is a cost it would prefer not to pay, and markets know it.

The indicators to watch are the result of the 20 July election and any fiscal package that follows, the demand at the next super-long auctions, and the Bank of Japan's review of its purchase plan. Monthly data on Japanese purchases of foreign bonds will show whether the repatriation has started. A stronger yen alongside rising domestic yields would be the clearest sign that money is coming home, since hedged foreign bonds would then look worse on both counts.

Japan is ceasing to anchor the global carry trade. If 30-year yields hold near 3.2 per cent, Japanese insurers and pension funds will probably bring money home over the coming months, and holders of Treasuries and Bunds will have to find buyers to replace them, most likely at higher yields. The likeliest first sign will be thinner Japanese bids at Treasury auctions this autumn, and a firmer yen by the year-end.