Shigeru Ishiba, Japan’s Prime Minister, warned the country’s Parliament on Monday that his debt-strapped government’s position was “worse than Greece”, signalling just how vulnerable the world’s third-largest economy could be to a meltdown if markets lost confidence.
The wider fear is that Japan is a canary in the coal mine. In a world of Donald Trump-induced volatility and uncertainty, bond market investors could quickly lose faith in any one of the debt-dependent governments of the West.
“The pressure on both Japanese and US bonds this week is a sign bond traders are willing to punish high-debt nations with large deficits,” says Kathleen Brooks, an analyst at XTB.
“This is an issue that has hurt the UK in the past, it is weighing on the US right now, and Japan is also coming under the spotlight.”
Jittery investors are demanding more reward for the growing risk of holding long-term government debt by marking down the price of bonds and driving up their yields.
If the yields rise consistently, governments in countries such as Britain will have to spend even more taxpayer money on interest payments.
Since the post-pandemic inflation crisis sent interest rates surging around the world, the door has been slammed on a decade of cheap money that encouraged governments to rack up borrowing rather than cut spending or raise taxes. It has also left finance ministers such as Rachel Reeves in a painful political bind.
A shaky economy
The Tokyo tremor began on Tuesday, when the government tried to sell 1 trillion yen ($12 billion) of March 2045 bonds and encountered lacklustre demand.
The average bid-to-cover ratio, which measures investor appetite, dropped to 2.5 – the lowest since 2012. The 1.14-point gap between the average and lowest-accepted prices, known as the “tail”, was the longest since 1987.
Investors responded by pushing the Japanese government 20-year yield to the highest this century, and the 30-year yield to a record. The benchmark 10-year yield also surged.
The ever-increasing cost of borrowing will make life difficult for Ishiba, whose minority Government faces an upper house election in July – and with it, the temptation to promise tax cuts or spending largesse.
He tried to temper those expectations on Monday, reminding MPs that Japan’s long era of anti-deflationary zero interest rates was over.
“The government is not in a position to comment on interest rates, but the reality is we are facing a world with them. Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece’s,” he said.
International Monetary Fund data puts Japan’s debt-to-GDP ratio at 235%, well above the 142% rate in Greece, the epicentre of the 2009 eurozone crisis.
Katsunobu Kato, Japan’s Finance Minister, was even more stark, warning of the damage that could flow from the market ructions. “A loss of market trust in our finances could lead to sharp rises in interest rates, a weak yen and excessive inflation that would have a severe impact on the economy,” he said.
Japan’s economy already looks shaky, having contracted 0.2% in the first three months of this year from the previous quarter, as timid consumers kept their wallets shut.
Inflation is running at 3.6%, pushing the Bank of Japan (BoJ) to last year impose a positive interest rate for the first time since 2008.
Bonds struggle for buyers
For decades Japan’s bond market has seemed relatively relaxed about the country’s economy and public finances. But this was because the BoJ was buying up bonds to help boost the economy, owning about half the outstanding stock of bonds and creating a balance sheet bigger than Japan’s GDP.
Now the BoJ is trying to unwind this untenable position: it is spending ¥400 billion less on bonds per quarter as part of its fight against inflation.
But the bonds are struggling to find alternative buyers, even among other traditional stalwarts like the big Japanese life insurers and managed funds.
The BoJ will next month decide whether to stay the course on this sell-down from next year, which would still leave it buying ¥2.9 trillion every month.
On Tuesday the bank released a summary of the views it has collected from economists and traders, which varied from one extreme to the other: some urged the central bank to keep buying anything from ¥1 trillion to ¥3 trillion a month; others said it was time to stop buying altogether.
Some market participants hope the BoJ’s gradual withdrawal will help the Japanese bond market function more normally, even if the process of resetting prices is painful.
‘Japan is not alone’
But even if this normalisation process is necessary or desirable, it is being side-swiped by the broader ructions in the global economy.
Trump’s tariff tirade has clouded every crystal ball, putting markets on a hair trigger. Behind that, there are mounting worries about the sustainability of the American and other Western governments’ fiscal positions.
With few exceptions, these are mired deep in deficit and debt. The US Government is heavily funded by the BoJ, owner of more than US$1 trillion ($1700b) of US Treasury bonds, adding to the uncertainty.
Fred Neumann, the chief Asia economist at HSBC in Hong Kong, said: “Rising debt levels in developed markets have become a growing concern in recent years, and the seeming lack of urgency about fiscal consolidation is leaving government bond investors increasingly jittery.
“After years of generous spending and tax cuts, fiscal constraints are starting to bite. Japan is not alone in facing the need for budget consolidation, but volatility in other developed economies’ bond markets adds an extra layer of urgency to put the fiscal house in order.”
British and Japanese bond yields are related because the two are substitutes for each other, according to Paul Dales, chief UK economist at Capital Economics. But he says the big risk to the UK comes from the US.
He said “uncertainty and tighter monetary policy in the US can be imported into the UK”.
The US, which suffered a downgrade from credit agency Moody’s last week, has a government debt-to-GDP ratio of 123% and is rated by BNP Paribas as the most fiscally vulnerable developed economy.
An American “Liz Truss moment” is “a non-trivial possibility in current conditions”, the bank said on Tuesday. BNP Paribas expects Congress to tap the brake on the US deficit, but “perception can be reality in markets”.
Avoiding the tripwires
The ray of hope in Japan is that the markets will calm down and volatility will ease, even if yields never return to the level of previous decades.
Some investors, such as Vanguard and RBC BlueBay Asset Management, are doing some contrarian buying of 30-year Japanese bonds according to Bloomberg.
But that might not be enough to ease the squeeze, unless big Japanese money also starts to crowd in.
The next test of the Japanese litmus paper is barely a week away, when the Government will hold an auction of 40-year bonds. Investors are already nervous: the 40-year yield was up more than 10 basis points on Tuesday.
Will Japan blow up the world economy, including Britain’s public finances?
There are so many tripwires: the risk appetite of Japanese investment managers; the deliberations of the Bank of Japan; the election promises of Japanese political parties; and the continuing emanations on tariffs and tax cuts from the White House and Capitol Hill.
And those are only the biggest threads.
It’s a hard knot to unpick. Reeves will just have to soak up BNP Paribas’ pithy observation: “In the short term, concerns about debt sustainability provide just one more reason to predict unpredictability.”
