3 days ago
Japan's bond spasm hits a world without safe havens
TOKYO – Japan doesn't tend to interest global investors very much — until something here goes really, really wrong.
Exhibit A: Japan's US$7.8 trillion government bond market, which is suddenly sending sizable shockwaves around the globe. Ten days ago, Japanese government bonds (JGBs) were the usual snooze fest with ultra-low yields, sluggish liquidity flows and trading hours when most masters of the investment universe are switched off.
Yet a disastrous May 20 bond auction quickly thrust Japanese debt into the center of the global financial discourse. And for that, investors have Donald Trump and his tariffs to thank.
Japan is starting to wobble much like the US. The world's No 1 and No 3 economies are fending off 'bond vigilantes' at a moment when the euro's share of foreign exchange reserves is just 20%, suggesting global safe havens are increasingly hard to find.
Investors can't seem to decide which major economy is riskiest. The US and all things Trump? Japan and its lost-decade baggage and current inflation troubles? Or China, with its rising deflation and persistent property crisis? Perceptions on all three tend to ping-pong back and forth on any given day.
The plot thickened further during US hours on Wednesday (May 28) when the US Court of International Trade ruled that the Trump administration lacks the authority to impose sweeping tariffs. At least for now, it could bring Trump's trade war to a screeching halt (Trump is already appealing the ruling).
Might Trump just try to ignore the ruling? Also, Trump has been raging this week about the rise of the 'TACO trade' on Wall Street, a Financial Times-coined acronym meaning 'Trump Always Chickens Out.'
Trump seems aggrieved, too, that China hasn't stepped forward to offer loads of trade concessions since he cut tariffs to 30% from 145%. News that the US will begin revoking visas for Chinese students suggests the trade war isn't going away while hopes for a 'grand bargain' trade deal wane.
At the moment, it's Japan's turn in global headlines. Its dubious status as the most indebted developed nation is a surprise to no one. Tokyo's 260% debt-to-GDP ratio is part of investors' thought processes when buying JGBs. Or, for that matter, Nikkei 225 Stock Average stocks.
For two years now, the Bank of Japan has been reducing its vast holdings of government debt, part of efforts to normalize the rate environment.
Since 1999, the BOJ has held the benchmark rate at, or near, zero. The policy was necessitated by the same reason Japan's national debt is so titanically large: fallout from the 1990s bad-loan debacle.
All that debt issuance helped Japan grow modestly year after year. And the BOJ's aggressive JGB purchases — it holds well over 50% of all outstanding securities— helped maintain calm in the market. Until now, it's kept JGB yields from getting out of line.
The BOJ's tapering policy was going well enough. Since July 2024, Governor Kazuo Ueda has been cutting purchases by 400 billion yen ($2.8 billion) each quarter. The BOJ even managed to hike official rates to 0.5%, a 17-year high.
Then Trump 2.0 arrived to launch a trade war with every economy of scale. The tariffs triggered near-unprecedented turmoil first in US Treasury securities and then in debt markets everywhere. Including Japan, where yields have spiked in headline-grabbing ways.
The volatility culminated last week with a 20-year bond auction that absolutely flopped. The typically routine sale of $6.9 billion issues maturing in 2045 drew the least interest since 2012. The 'tail,' the gap between the average and lowest-accepted prices, was the worse since 1987.
Suddenly, #JGBCrash was trending in Asian cyberspace. It was Tokyo returning the favor, sending shockwaves back toward the US. Earlier this week, US Treasury Secretary Scott Bessent said worries about Japan were indeed pushing US yields higher.
Some argue Japan worries are much ado about nothing. For example, Japanese Finance Minister Katsunobu Kato's team managed to tame markets by signaling a shift in bond issuance toward shorter-dated securities.
It helps explain why a less-than-stellar 40-year bond sale on Wednesday didn't slam world markets. Markets are betting that, for now, Tokyo is on top of things.
'We maintain our long-standing view that the challenges in the JGB market are technical rather than structural, says Masahiko Loo, senior strategist at State Street Global Advisors. 'These issues are largely addressable through adjustments in issuance volume or composition.'
Loo adds that 'we believe the concern on loss of control over the super-long end is overblown. Around 90% of JGBs are domestically held, and the 'don't fight the BOJ/Ministry of Finance' mantra remains a powerful anchor. Any perceived supply-demand imbalance is more a matter of timing mismatches, which is a technical dislocation rather than a fundamental flaw. We expect these imbalances to be resolved as early as the third quarter.'
The MOF's announcement that it might reduce the size of bond issues, Loo says, 'reinforces our view.'
Yet risks abound. In a note to clients, Macquarie Bank analysts warn that rising JGB yields could be a 'trigger point' that catalyzes a wave of capital repatriation with Japanese investors pulling funds from dollar assets.
Albert Edwards, global strategist at Societe Generale, goes further, arguing a Japanese yield surge could 'trigger a global financial market Armageddon.'
Goldman Sachs analysts think the JGB market is a 'canary in the global duration coal mine.'
Realizing that, and not wanting to trigger a global meltdown, Tokyo may reduce issuance of super-long JGBs in July, easing market concerns, says Katsutoshi Inadome, strategist at Sumitomo Mitsui Trust Asset Management.
However, he adds, 'this offers only temporary relief and won't lead to a decline in Japan's debt balance. With the MOF likely doing its part, politicians now need to make efforts to avoid increasing debt.'
The timing of all this could scarcely be worse. Carlos Casanova, economist at Union Bancaire Privée, says that the market has been pricing in the possibility of slower growth and higher inflation.
'Compounded with technical factors in a notably illiquid market,' he says, 'this has exerted upside risks on JGBs, with the 10-year bond picking up to 1.50% and the 30-year soaring to 3.16%.
Yet where JGB yields go could have major implications globally. George Saravelos, head of FX research at Deutsche Bank, called the recent divergence between US yields and the yen exchange rate the 'single most important market indicator of accelerating US fiscal risks' because it shows foreign buyers are jittery about the US Treasury market.
'The Japanese yen is strengthening even as US yields are rising,' Saravelos says. 'We consider this as evidence that foreign participation in the US Treasury market is declining.'
All this has the BOJ throttling back on rate hikes. Over the last two years, Governor Ueda's team managed to boost the benchmark to the highest since 2008.
Now, fears that Japan is skirting stagflation are getting in the way. GDP shrank 0.7% in the first quarter, while consumer price inflation is running at a 3.6% rate. That's nearly double the BOJ's 2% target.
Recent market turmoil is 'adding to the Bank of Japan's challenge of balancing price pressures against growth headwinds from US tariffs,' UBS analysts write in a report. UBS thinks the BOJ's next tightening move won't come until 2026.
One reason for the BOJ is treading so carefully is indications that regular levels of market liquidity are becoming sporadic.
'If the BOJ makes no changes to its purchase reduction plans despite the survey showing a decline in market functioning, it may send the wrong message that it intends to continue reducing purchases without taking market conditions into account,' says Naoya Hasegawa, chief bond strategist at Okasan Securities.
The direction of US Federal Reserve policy is its own mystery. A summary of the May 6-7 meeting of the Federal Open Market Committee suggests the central bank has some misgivings about the volatility in US fiscal and trade policies.
'Participants agreed that uncertainty about the economic outlook had increased further, making it appropriate to take a cautious approach until the net economic effects of the array of changes to government policies become clearer,' the minutes said.
'Participants noted that the Committee might face difficult tradeoffs if inflation proves to be more persistent while the outlooks for growth and employment weaken.'
Yet the Fed's own economic forecast 'puts the economy squarely in stagflationary territory,' says Omair Sharif, president of advisory Inflation Insights.
Not surprisingly, a new JPMorgan Chase survey flags growing fears about the stability of the $29 trillion US Treasury market. Top-line worries include a nearly $37 trillion national debt, Trump's trade war and a chaotic legislative environment on Capitol Hill.
The bottom line, as Leah Traub, a portfolio manager at Lord Abbett & Co tells Bloomberg, is that 'demand for longer-term securities is diminishing at the same time as supply is growing.'
This means that the typical US safe haven of choice is losing credibility as Japan wobbles, too. If ever there were a moment for China to step up and try to fill this growing vacuum, it's now.
Follow William Pesek on X at @WilliamPesek
