Japan's borrowing costs have surged to their highest level in three decades, driven by investor concerns over the plummeting yen and the impact of a $2 trillion long-term spending plan on the nation's massive debt.
Japanese government bonds have faced intense selling pressure this year, pushing the benchmark 10-year yield to 2.87% on Wednesday, its highest point since 1996.
Investors indicate that policies by Prime Minister Sanae Takaichi, centered on a 14-year, $2.3 trillion spending initiative, are intensifying the sell-off in long-term bonds. Some also worry that the Bank of Japan, which raised interest rates to 1% last month, may fall behind the curve, allowing inflation to exceed its 2% target.
"A combination of the BoJ's continued caution on further [rate hikes], persistent yen weakness, and concerns around fiscal policy is making the long end of the Japanese government bond curve particularly vulnerable," said Alex Everett, Investment Director at Aberdeen Standard Investments.
Market anxiety over long-term risks is evident in the premium investors demand for Japanese 10-year borrowing relative to 2-year borrowing. This spread has widened from less than 1 percentage point in April to 1.4 percentage points currently. In contrast, this spread has been flat or declining recently in other major bond markets like the US and Germany.
Investors warn that the sharp rise in Japan's borrowing costs is putting pressure on its enormous sovereign debt pile, which is equivalent to over 200% of GDP. The yield on the nation's 30-year bond has surged above 4% this year, hovering near the intraday record high of 4.2% set in May.
For years, with the Bank of Japan maintaining negative policy rates and buying bonds in large quantities, investors were content to purchase Japanese debt. However, this dynamic is shifting as monetary policy tightens.
"What is playing out is a reflection that Japan built the world's largest [sovereign] debt pile on the assumption that money would be free forever. The market is now violently withdrawing from that assumption... Tokyo must refinance the past and fund the future at a price it has not paid for a generation," said Stephen Jones, Chief Investment Officer at Robeco Investment Management.
Stephen Spratt, rates strategist at Société Générale, noted that Japan watchers are concerned that government borrowing costs may start rising faster than income growth, worsening its debt dynamics. He added, "We think the tipping point is somewhere above 3% [on the 10-year yield], but when you get to 3%, people start asking questions." Yields move inversely to prices.
This year, fund managers have been startled by the simultaneous decline of the yen and Japanese bond prices, which typically move in opposite directions due to interest rate expectations. Despite repeated interventions by the Bank of Japan in recent months to support the currency, the yen fell to a 40-year low last month. Inflation edged up to 1.5% ahead of the central bank's meeting last month.
"Inflation is no longer ignorable, government borrowing remains large, and the BoJ is still normalising policy. The combination is making the market more sensitive to the fiscal dynamics than it has been for many years," said Frazer Lundy, Head of Fixed Income at Aviva Investors.
During Japan's era of deflation, years of asset purchases and low policy rates kept yields on Japanese government bonds near or below zero, a period that left the Bank of Japan holding a significant portion of the sovereign bond market.
Unlike other major central banks such as the Bank of England and the US Federal Reserve, the Bank of Japan is still buying bonds. This helps sustain the viability of Japan's massive government debt.
Some argue that debt concerns are mitigated by Japan's substantial assets, which bring its net debt closer to 100% of GDP.
However, in a sign of authorities responding to the bond market sell-off, the Bank of Japan stated at its meeting last month that it would stop reducing its monthly bond purchases from next year, instead stabilizing them at around ¥2tn ($12.5bn) per month.
Tomohiro Ota, senior economist at Goldman Sachs, warned that Japan could enter a "vicious cycle" where fiscal worries push up interest payments, thereby exacerbating fiscal tightening.
Others worry that Japan is succumbing to a form of so-called "fiscal dominance," where policymakers artificially suppress interest rates and allow inflation to erode government debt. Lee Hardman of MUFG said the Bank of Japan's cautious approach to raising rates is feeding "perceptions of this strategy."
Some institutional investors fear that a significant rise in Japanese government bond yields could attract capital from other sovereign bond markets, potentially pushing global yields higher. This could intensify tightening pressure in other countries, such as the UK, where long-term borrowing costs hit multi-decade highs earlier this year.
"That is the risk, that it could trigger a global sell-off," said Ludovic Subran, Chief Investment Officer at Allianz, adding that this represents "another layer" of potential stress for global markets.
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