Japan's political shift and bond market impacts

What is causing Japanese Government Bond (JGB) yields to rise and could the country’s borrowing costs reach a point where they are unsustainable?

The recent rise in JGB yields was triggered after Prime Minister Sanae Takaichi proposed a two-year suspension of Japan’s consumption tax on food ahead of a snap election, which intensified concerns about the health of the country's public finances. With Takaichi and her LDP party having secured a strong mandate to govern, those worries may well linger.  

The bond market has been already sensitive to the prospect of reflationary policies under Takaichi, who is known for her desire to boost government spending. 

As a result, the sustainability of Japan’s rising debt servicing costs is now under scrutiny, as evidenced by several poor bond auctions that have forced the Debt Management Office to reduce issuance of long-dated JGBs. 

But we believe such concerns are overblown for several reasons.

First, Japan’s fiscal deficit has been narrowing. It stands at a healthy 0.5% of GDP, which is far lower than the average for developed economies of around 3%.

Second, the return of inflation has boosted tax revenues, which has in turn lifted nominal GDP growth.

As a result, Japan’s debt to GDP ratio has fallen to around 226% from around 260% at the peak of the pandemic.IMF: https://www.imf.org/external/datamapper/profile/JPN

Importantly, JGB’s investor base is predominantly domestic: the Bank of Japan holds around 50% and most of the rest belongs to local private institutions — banks, life and non-life insurers and pension funds. This helps keep financing conditions stable.

Third, the structure of Japan’s public liabilities means its debt servicing costs will rise at only a very gradual pace. The Cabinet Office projects that interest payments on public debt will rise to just 2% of GDP by 2028 from below 1.5% currently. This very gradual increase reflects the fact that the weighted average interest rate on outstanding debt is just 0.8%, while the average maturity of that debt is longer than 9.5 years.  

In our debt sustainability scorecard, which takes all of this into account, Japan remains in the top quartile – the most sustainable group – alongside Switzerland and Denmark.

That said, the new administration; ability to spend might be more limited than assumed. A warning comes from insurance companies, major JGB holders, which have been forced to sell down their holdings as the spike in yields caused a mismatch in the duration – or interest rate sensitivity – of their assets and liabilities. While we believe bond yields are close to their peak, investors can’t be complacent about the residual risks facing Japan.

In what ways might a rise in JGB yields affect other government bond markets such as the US and the euro zone? Might Japanese investors who hold foreign bonds be tempted to switch back into what are now higher yielding domestic securities?

Developments in Japan have served as a reminder that when public debt levels are high worldwide, changes in fiscal policy can trigger market panic, like we saw in the UK gilts market after Prime Minister Liz Truss announced unfunded tax cuts.

The rapid increase in JGB yields has certainly eroded the relative appeal of foreign investments for Japanese investors.

But while some commentators believe higher yields might incentives Japanese investors to repatriate capital currently held overseas, we don’t expect a sudden shift.

Japanese investors generally understand that Japanese real rates have been maintained at ultra-low levels for decades and, as a result, are not likely to change their holdings unless there is a significant market shock. Rather, we would expect to see continued rotation out of US dollar debt into European debt as Japanese investors continue to seek diversification in their offshore holdings.

One factor that could however trigger a large repatriation trade is the behaviour of large Japanese state institutions, such as the Government Pension Investment Fund (GPIF). Should market volatility abate, there is the possibility that the GPIF chooses to reduce its foreign holdings in favour of domestic assets, giving the green light for other investors to do the same. 

The yen carry trade – a popular strategy that saw investors borrow funds in the low-yielding yen to finance investment in higher yielding assets – might now be winding down. If so, what effects might this have on global bond markets?

As with many large macroeconomic imbalances, if the behaviour of Japanese investors changes and repatriation flows build, this could have a negative effect on prices of bonds, stocks and currencies worldwide. The first impact will be seen in currency markets as domestic investors sell their dollar and euro exposure in favour of the yen, thereby strengthening the Japanese currency.

However, the interest differentials will continue to drive appetite for carry trades. As long as the interest rate gap remains between the yen and other currencies, the Japanese unit should remain a funding currency, even if the trade is less profitable than before.