Unusual turbulence has struck the usually calm Japanese government bond market, causing its biggest disturbance in many years. For many years, the Bank of Japan’s (BOJ) easy money measures, including YCC, made sure interest rates were exceptionally low. Now that the BOJ is slowly easing its unique measures, markets are reacting strongly. Yields are at their highest in decades and this strong reaction has led the BOJ to respond in a way that will likely be felt all over the world.
It became highly clear that something was wrong when demand for Japan’s long-term bonds, especially 20-year and 30-year notes, fell sharply. Yields rose to their highest levels in many years because Japanese investors and others were wary to buy and the extra government borrowing became more expensive. Governor Kazuo Ueda’s efforts to bring back monetary normality, after years of deflation, led the BOJ to quit its YCC program and, in March 2024, the bank officially embarked on the scrapped program, accounting for the drastic changes seen in interest rates recently. How to remove decades of stimulus without causing the market to collapse was a tough problem.
Though the markets have been volatile, some believe the outcome is due to a strategic shift by the government, not its central bank. It is widely being discussed that Japan's Ministry of Finance could soon shift to issuing less super-long-dated debt and more short- or medium-term bonds. This maneuver hopes to lessen strain in long-term bonds, where demand has been lower and keep the market stable without the central bank using a direct, significant purchase program. It is a gentler way, yet it can have important results.
This is much more than just tweaking numbers for the US; it becomes vital for how the world reacts. For a long time, Japan’s low interest rates made the yen the preferred currency for investors involved in the “yen carry trade,” which means borrowing at low yen rates to purchase high-yielding assets abroad. When Japanese interest rates rise, investors in the carry trade will unwind their positions, possibly sending a lot of money to Japan and making markets volatile across the world.
Furthermore, Japanese institutional investors, particularly giant life insurance companies and pension funds, have been colossal buyers of foreign sovereign debt. With yields at home becoming more attractive and facing unrealized losses on their domestic bond holdings, the incentive to repatriate capital and buy JGBs increases. Should these Japanese behemoths significantly pull back from international bond markets, it could exert upward pressure on yields in major economies like the U.S., driving up borrowing costs globally.
The world's central banks are watching Japan's experiment intently. The BOJ's attempt to navigate a gradual exit from ultra-loose policy, now augmented by a subtle supply-side adjustment in bond issuance, offers a unique blueprint – or a cautionary tale – for other nations contemplating their own exits from extended periods of low rates and quantitative easing. How Japan manages to stabilize its bond market without derailing its fragile economic recovery will provide invaluable lessons on the complexities of post-stimulus financial landscapes. Japan's “quick fix” may be stealthy, but its reverberations could redefine the global financial playbook.
