Rates: Sleight of hand

In response to Japan's difficulties in placing its debt, the government has come up with a solution: limit long-term auctions and focus on short maturities. Behind this sleight of hand, which impresses no one and causes considerable concern, it is important to understand that the country is facing real difficulties and that its options are limited.

The unsustainable level of US debt, which now exceeds 125% of GDP, regularly makes the headlines and has prompted rating agency Moody's to downgrade its credit rating from AAA to AA1. What can be said about Japan, whose debt, expressed as a percentage of GDP, stands at 250%? And how is it that this situation has not already led to a major bond crisis?

On the one hand, Japanese debt is mainly held by the Japanese themselves, so it is less sensitive to external influences. On the other hand, the Bank of Japan (BoJ) has intervened massively in the bond market for years, buying more than half of all maturities at auction. This process of controlling the yield curve was intended to pull Japan out of the deflationary spiral it was caught in. However, the land of the rising sun has since been overtaken by inflation, leaving the BoJ with a mountain of paper that is depreciating as yields normalize (i.e., rise). With deflation now seemingly a thing of the past, the Japanese central bank no longer needs (or wants) to buy JGBs (Japanese government bonds). As a result, the bond market is now facing a lack of serious buyers, which is why it is struggling to sell its long-term government bonds. Investors seem more than skeptical about Japan's ability to deal with its debt without causing a major crisis.

In a way, the BoJ has a choice between a rock and a hard place. If it does nothing and simply allows yields to drift, it will jeopardize the entire banking ecosystem, which is awash with JGBs and facing massive latent losses. At the same time, it risks triggering massive deleveraging, of which we saw a small glimpse in August 2024, when global stockmarkets fell sharply and the yen soared. In addition, Japanese investors could be tempted to repatriate their foreign-denominated assets to take advantage of higher domestic yields. Conversely, if it continues to buy bonds on a massive scale to support the system, it will only postpone the problem while fueling inflation.

Investors will therefore be keeping a close eye on the BoJ's next meeting, scheduled for June 17, when it is expected to detail changes to its QT/QE program. It should also be borne in mind that the Japanese government is considering tax cuts that are likely to weigh, at least temporarily, on the public deficit, increasing the need for financing in an already complicated environment.