The round trip in long-term government borrowing costs in the past week has market analysts and financial journalists wondering what is going on in the bond markets. This time last week, non-financial news media were leading on headlines about the UK’s 30-year gilt yield — the asset that was caught up in the Liz Truss mini-budget meltdown — hitting its highest since 1998. Yet as I write, the sell-off has entirely reversed and yields are back within the range they were trading within in early August when no one was paying attention. The same is true of the equivalent US and eurozone bond yields.
The gilt panic seemed to have vindicated commentators who a week previously were spuriously warning that the bankrupt UK economy could not finance itself and needed to be bailed out by the International Monetary Fund. Bond holders seemed to have taken heed of the warnings, returned to their trading desks after the summer break and yanked up the UK’s borrowing costs, accelerating the crisis that they were told was going to happen.
I have written about why commentators who resort to panics about IMF bailouts misunderstand the nature of the fund and what it does. And my colleague David Smith has brilliantly explained why comparisons with the 1970s are based on a specious reading of the dynamics in the sterling money market that eventually resulted in an IMF package.
So no, the UK is not on the brink of a “buyers’ strike” where private creditors dump gilts and refuse to turn up to buy newly issued bonds, no matter the returns on offer. Last week’s breathless market meltdown commentary happened to coincide with two gilt auctions from the Debt Management Office that attracted record amounts of investor interest in gilts.
So what is going on beyond panicked narratives and bad fiscal vibes? And is this really all about the UK?
On the latter, most certainly not. Investor squeamishness about long-dated bonds has been attributed to a few causes: the ever- expanding US fiscal deficit, a Federal Reserve under the thumb of President Trump and another round of political instability that will prevent France from enacting the painful austerity needed to stabilise its public finances. These are all sensible and valid concerns that would lead some to shed their exposure to longer-dated government bonds. Yet, by Friday, investors had piled back into the same assets that they were dumping en masse days earlier, which suggests that none of these fears was that deeply held in the first place, and at least not enough to turn away juicy returns in excess of 5 per cent on “safe” government debt.
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Bubbling in the background are perennial factors, such as the fading demand of pension funds that no longer need to match their liabilities by holding on to long-dated gilts, speculation about tax rises in the budget, which will now drag on to late November, and the Bank of England’s ill-timed decision to sell back its gilts as part of its quantitative tightening programme.
Again, these are all legitimate variables but a debt crisis they do not make. Instead, one huge change in the global bond markets that is scarcely mentioned in the western media is the brutal sell-off in Japan, the world’s second-biggest bond market as measured by outstanding bonds issuance.
Japan is the sole sovereign bond market whose longer-dated yields have not reversed course over the last week but continued climbing. Over the past year borrowing costs on 10-year Japanese government bonds have almost doubled from a low of 0.8 per cent to 1.6 per cent; its equivalent 30-year bonds now yield about 3.3 per cent after trading below 2 per cent last year. A holder of Japanese government bonds would have lost more than 15 per cent over the past three years.
This has been a year of reckoning for Japan’s bondholders and it matters for the rest of the world. Japan has been the paradigmatic example of an economy whose central bank has maintained rock bottom interest rates and carried out mass quantitative easing for decades to try to increase inflation, while fiscal policy was meant to stimulate sluggish growth. Now Japan may have finally won its battle to raise prices, with consumer price inflation running above 2 per cent, and interest rates are on the climb.
“For a long time, super-low interest rates have suppressed western bond yields. That ship has now sailed into the horizon and the second-biggest bond market in the world is quite capable of driving western yields sharply higher until something, somewhere snaps,” Albert Edwards at Société Générale said.
Ultra-low Japanese bond yields helped to anchor debt costs in the rest of the rich world and the weak yen led Japanese investors to pile into US assets such as bonds and equities to earn returns. Japan is the largest foreign holder of US government debt. But with Japanese bond valuations falling and providing juicer returns, “This could entice Japanese investors to return home, and unwinding the carry trade could cause a loud sucking sound in US financial assets,” Edwards said. “I would rank trying to understand and follow the surging long end of the Japanese government bond market as the number one most important thing for investors at the moment.”
Indebted western economies have been warned of the dangers of “turning Japanese”: ageing societies, closed off from migration, with high debt levels and sluggish nominal growth. Politically, though, Japan resembles a textbook western economy where inflation is generating grievances about the cost of living, the weak currency is eroding consumer purchasing power and populist forces are on the march. Shigeru Ishiba resigned as prime minister at the weekend after his once-dominant Liberal Democratic Party was forced to find coalition partners to form a parliamentary majority. Political instability is becoming a feature of Japan. Bond markets can no longer rely on Japanese assets or its politics to remain an outlier. The blowback will be felt in the rest of the world.