While Trump blusters, Japan’s debt quietly looms over markets
President Trump has been playing with his yo-yo again this week, flicking out the threat of big tariffs to get his way on Greenland, only to flick it back in again within a couple of days. And again investors who ignored Trump’s bluster were right to do so. Shares in Nvidia, the world’s most valuable company and now a good barometer of wider stock market sentiment, dropped from $186 to $178 at the start of the week, but had recovered almost all the lost ground when the market closed on Thursday.
All the Trump noise at Davos took the attention away from something else that happened this week, something with the potential to be more damaging than a year’s worth of wild presidential policy announcements. Japanese bond yields rose steeply at the start of the week, aggravating some fixed-income investors’ long-held fears that its sovereign debt market, long a placid pool, was about to become turbulent, with worrying consequences for bond and stock markets around the world.
First, Japan has a shedload of debt. Here in the UK we are concerned that our debt to GDP ratio — the size of the total national debt compared with the economy’s annual output — has been hovering close to 100 per cent for the past few years. Japan’s is 235 per cent. At the turn of the century it was 135 per cent and has climbed steadily as successive administrations have run deficits; deficits made all the larger by ministers spending billions on stimulus programmes aimed at flogging some life into the economy.
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With that much debt, you might think that Japan would be paying a very high interest rate on its borrowing. It’s not. In the UK, the yield on the ten-year gilt is 4.48 per cent and has been above 3 per cent for the past three years. In the United States the ten-year treasury yield is 4.25 per cent and has been north of 3 per cent since for about the same time. The ten-year Japanese bond yield was less than 1 per cent until July 2024. It did then start to climb, but even with this week’s activity it is still only 2.24 per cent.
One explanation for the low borrowing costs could be that international investors think Japan is a great credit risk. That has been true, but the real reason for the low rates is that they have been kept there by design. Japan’s central bank is, like the Bank of England, independent and tasked by the government with keeping inflation at 2 per cent.
The Japanese economy’s persistent problem has, however, not been inflation — control of which requires higher interest rates — but deflation. The Bank of Japan has persistently intervened in the markets, buying and selling Japanese government debt, to keep rates low. The programme was called “yield curve control”. The bank set a target for the yield on the ten-year bond, and then did whatever it had to do to make sure the market yield hit the target. When the programme started in 2013 the target was 0 per cent. It was moved to 1 per cent in 2023. The bank abandoned the formal yield control programme in March last year, although it said it would still jump back in if it felt the need.
That has removed one safety net, and another one took a battering this week. On Monday Sanae Takaichi, the country’s first female prime minister, called a snap election, with parliament dissolved on Friday. Snap is apt in this case, as the vote will take place on February 8, making it the shortest election campaign since the Second World War.
On Tuesday she announced her cornerstone policy: a two-year suspension of a VAT-style tax on groceries and drinks — an obvious attempt to win over voters by easing the cost of living. This sparked the big bond sell-off. Investors took fright at the strain this would place on the public finances. The consumption tax takes in £24 billion a year, about 6 per cent of the total tax take. That might mean even more government borrowing and an even-greater mountain of outstanding debt.
Yields look likely to go higher, which could have some intriguing consequences. Japan is the world’s second biggest creditor nation (Germany overtook it at the end of 2024) meaning its institutions hold a large amount of foreign assets, about £2.75 trillion. One third of that is in US government debt, which is probably not surprising. If you are a Japanese insurance company or pension fund looking for a safe investment, why would you buy a Japanese government bond yielding 2 per cent (or in the recent past, nothing) when you could have a US Treasury at 4 per cent-plus?
What happens if that changes and the yield difference is much less? Some of the Japanese money would shift back home. That would take one of the big buyers of US Treasuries off the market and probably result in even higher US Treasury yields. The ripple effects could come here too. If yields rise across the board, money could be sucked out of equity markets and into bonds.
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Some analysts have been warning about Japan being the catalyst for a market slump for a while. Albert Edwards, the “perma-bear” strategist at the French bank Société Générale wrote a paper in May last year with the no-nonsense title, “Are you ready for Japan to trigger global financial market Armageddon?” He has returned to the subject a few times since, warning about rising bond yields and pointing out that many recent big developments in markets have happened first in Japan.
Those same markets, however, have shrugged off all kinds of reasons to be bearish in the past decade, and those who took fright at previous warnings have lost out on potential gains. In May, when Edwards was sounding the alarm on Japan, Nvidia was at $135 a share. If you had sold then you would have missed a rise in its price of $45, hardly to be sniffed at. Having said that, Japan is clearly not a trivial issue, with a possible sea change in one of the world’s biggest bond markets. It is definitely worth keeping an eye on the February 8 election.
Dominic O’Connell is business presenter for Times Radio
