The Japanese government bond (JGB) market was for long a place of low to negative yields and relatively little foreign investor participation, despite its huge size. But the market is now moving into the limelight as an arbiter of global capital flows.
The reason for this is that yield differentials between Japan and elsewhere, especially the US, are beginning to narrow. This could create big shifts in international capital flows that could impact consumption and investment.
As the Washington-based Institute of International Finance (IIF) says in a report in January, “a critical transmission channel for these shifts in global capital flows runs through Japan”. It notes that long-term yields have risen since 2023, reversing Japan’s long-standing role as “a global anchor of low rates”.
“Japan sits at the intersection of global savings and global duration, and even small changes in relative yields can have outsize effects on global portfolios,” the report says. “With capital remaining highly mobile, rising Japanese yields can trigger portfolio rebalancing and relative-value adjustments that spill over into global bond markets.”
JGB yields have spiked sharply in anticipation of an era of fiscal expansion in Japan. For the first time ever, the yield on 40-year bonds has moved above 4% while the yield on the ten-year benchmark bond has topped 2%.
A recent report in the Financial Times described the “yield panic” this could create among investors.
Elections awaited
The path of yields in Japan will depend to no small extent upon the outcome of the Lower House parliamentary election scheduled for February 8. Prime Minister Sanae Takaichi’s Liberal Democratic Party is expected to secure a majority, or at least increase its coalition partner-assisted majority.
Takaichi advocated fiscal expansionary policies in the run-up to her election as prime minister late last year. Although she has since downplayed that aim somewhat, financial markets believe that if and when her political power base is consolidated, she will pursue economic expansion based partly on tax cuts.
This is at a time when public debt levels in most major economies are at or near record highs and when central banks, including the Bank of Japan, are planning reduce the size of their balance sheets, which will throw the onus of funding rising public debt on market investors.
The direction of international capital flows will be key. Japan has become a critical conduit in this regard. As the IIF report notes, capital flows out of Japan and into the US when Japanese interest rates were at ultra-low levels may be about to go into reverse.
The Investing.com financial website observed recently that JGBs were for decades the “ballast of the global rates complex” that kept yields elsewhere from drifting too far, too fast.
“You could pile on debt, run deficits, issue paper with abandon, and Japan would quietly absorb the shock by existing at yields so low they barely registered as a price signal. That era is over. The anchor has been lifted, and markets are only just starting to realise what that means,” according to the website.
This means there will be greater economic uncertainty from now on. And it also means that if and when a financial crisis should occur, it can no longer be taken for granted that major central banks will rush in to bail out the system.
