By Mike Riddell, portfolio manager of the Fidelity Strategic Bond fund
This new ‘fiscal dominance’ era has seen long dated government bond yields almost everywhere come under pressure. The yield on a 30-year US Treasury has climbed 0.7% since the beginning of 2024, while 30 year gilt yields have jumped 1%, and 30 year German government bond yields have soared 1.1% higher. This is nothing compared to Japan though, where 30 year JGB yields are almost 2% higher over the same period. If you’d bought the JGB 1.6% 2053 when issued at the end of 2023, you’d have lost one third of your money.
Normally, rate differentials drive currencies returns, so when a country’s bond yields rise relative to other countries, you’d expect to see its currency appreciate. But since the end of 2023, the Japanese yen has had the worst return of any major developed market or emering market currency. The classic EM crisis playbook tells you it is not a good sign when bond yields rise and the currency falls. And Japan is no emerging market country – it is the 4th biggest economy in the world, after the US, China, and just behind Germany.
How much debt does Japan have?
Lots. Japan’s gross government debt/GDP ratio is the highest in modern history at just above 250%, slightly more than the UK managed in the aftermath of WW2.
However, it’s not quite as simple as that. Japan also has a treasure chest of overseas assets, meaning that Japan has one of the biggest Net International Investment Positions (NIIP) in the world. Some therefore argue that net debt/GDP is a better metric for Japan, which was last measured at around 120% of GDP. The increase in the value of Japan’s overseas assets lately, particularly when measured in yen terms, means it’s probably considerably less than this today too. On a net basis, therefore, Japan may now have a lower public debt ratio than the US or Italy, and similar to France.
And unlike the US or France, Japan’s debt ratios haven’t been deteriorating much lately either. Thanks to Japan’s (still) very low interest rates, the interest cost from even its gross debt mountain is less than 2% of GDP, about half the US. Its budget deficit for this fiscal year of around 2.5% is also about half that of the US or France.
So we can all relax?
The Japanese sovereign surely does not have a solvency problem. Japan owes almost all of its debt to itself, and the overseas assets do count for something. It has the advantage of simply weakening its exchange rate to very quickly improve its debt sustainability position.
But if you borrow lots of money at close to zero interest cost, and you use the proceeds to buy overseas assets, does that mean that you have zero debt? No. The value of the assets can go down, the value of the domestic currency can go up, and the country’s interest rate can go up (which is exactly what’s been happening in Japan) so the debt is no longer free.
You also have to consider recent political developments in Japan. Prime Minister Sanae Takaichi has won a landslide election victory on a mandate to pursue more aggressive fiscal policy. Japanese government bonds have already been under considerable pressure, which in Japan’s case is more to do with a lack of demand for longer dated JGBs rather large persistent fiscal deficits. But even if demand for long JGBs remains stable in future, and supply increases, then yields can only rise.
This is where what happens in Japan does not stay in Japan. The higher JGB yields go, the more incentivised colossal domestic Japanese investors are to sell overseas assets and bring the money back home to higher yielding JGBs. Hence a JGB selloff quickly leads to a global sovereign bond selloff, and we’ve seen this play out a few times already in the past two years.
Japan plc won’t be immune to higher JGB yields domestically either. Eventually, soaring JGB yields will put pressure on any domestic financial institution that has these bonds marked as ‘hold to maturity’ on their book, since it creates massive unrealised losses, which can become realised if depositors withdraw money. We saw this play out in the US regional bank crisis in 2023. Similarly, in Japan, it’s likely the ‘Shinkin’ smaller regional co-operative banks that could get into difficulty.
So although the Japanese government itself should be fine, there remain substantial risks that contagion from a pronounced JGB selloff could quickly spread to US Treasuries or European government bonds, where debt sustainability is not so robust. Or it could spread to the Japanese financial system itself.
And given that PM Takaichi appears inclined to pursue a more expansionary fiscal approach, this risk does not seem fully priced in by markets. We remain cautious of longer dated bonds globally, and if a weaker yen is what rescues Japan, then that seems worth positioning for too.
