Japan returns to scene of BOJ’s crime in 1999

TOKYO — Bond traders seem to be sending a message to the Bank of Japan and the Ministry of Finance that the late 1990s are back.

Yet far from partying like it’s 1999, the rise in 20-year yields back to levels from that year suggests trouble ahead for Asia’s second-biggest economy — and perhaps global markets.

It was 26 years ago when the BOJ cut rates to zero, the first major monetary authority to do so. This week, the 20-year Japanese government bond (JGB) rate rose to 2.655%, the highest level since 1999. It sparked a level of volatility Tokyo markets haven’t seen in years.

Since 1999, a succession of BOJ leaders have been trying to get short-term rates closer to 1% than 0%. To no avail. Today’s BOJ Governor Kazuo Ueda has gotten no further away from zero than 2003-2008 Governor Toshihiko Fukui.

Between 2006 and 2008, the Fukui BOJ board managed to scrap quantitative easing, a policy dating back to 2001. Fukui pushed benchmark rates to 0.5%, the same level as today. Then came the 2008 “Lehman Shock,” and with it a return to QE and zero rates.

In 2013, the BOJ went ever further than that. Under the leadership of then-Governor Haruhiko Kuroda, the BOJ hoarded JGBs and stocks as never before. By 2018, the BOJ’s balance sheet topped the size of Japan’s $4.2 trillion economy, a first for a Group of Seven member. The BOJ’s yield-curve control policy effectively pushed rates into negative territory.

Enter Ueda, who took the helm in April 2023 determined to normalize Japan’s rate environment. Then came US tariffs. The trade war has the Ueda BOJ halting its rate hike cycle.

With Japan seen growing all of 0.7% this fiscal year and tariff-related storm clouds gathering, the BOJ is essentially stuck at 0.5% until it knows where US President Donald Trump plans to take his trade war in the months ahead. It’s not clear even Trump knows, as China, the real target of tariffs, is slow-walking trade deal negotiations.

If Chinese leader Xi Jinping opts against the splashy “grand bargain” deal of Trump’s dreams, the US leader might lash out everywhere in anger. Officials in Tokyo worry Trump might then impose a universal tariff stacked on top of the 15% rate Japan negotiated.

In the interim, China concerns abound, keeping the Tokyo policymakers stuck in economic limbo. Mainland growth appears to be slowing across the board. If the BOJ continues tightening as China slows, might it just hasten Japan’s slide into recession?

Some economists think the BOJ will continue tightening. “With the economy holding up well and tariff-related uncertainties abating, the [BOJ] should feel comfortable with resuming policy normalization before long,” said Abhijit Surya, economist at Capital Economics.

Yet as economist Annabel Fiddes at S&P Global Market Intelligence pointed out, soft domestic demand and a darkening external scene are complicating Japan’s year. A “recovery in manufacturing output may be hard to sustain unless we see an improvement in sales in the near-term,” Fiddes said.

The plot thickens when you consider why JGB yields are returning to 1999 levels: worries that Tokyo is about to open the fiscal floodgates to juice the economy.

Japan has by far the worst debt burden among developed nations. By some measures, it’s 260% of gross domestic product. That might seem less troubling if Japan’s population weren’t shrinking and aging at a rate that worries demographers as much as holders of 20-, 30- and 40-year JGBs.

An added complication: how dismally the ruling Liberal Democratic Party performed in July elections. Odds are good that embattled Prime Minister Shigeru Ishiba will green-light increased public spending, a step that might irk credit rating companies.

“Looking ahead, with concerns about fiscal expansion remaining strong, the ultra-long-term zone as a whole is likely to face upward pressure,” wrote analysts at Mizuho Securities.

In July, net foreign purchases of JGBs maturing after 2045 fell to just $3.3 billion. That was just a third of the level of purchases in June, a sign Japanese debt may be losing its safe-haven bid.

On August 19, the MOF attracted only tepid demand for a sale of 20-year sovereign bonds. It’s become something of a pattern. Weak auctions in June and July spooked investors, too.

As Tokyo has difficulty selling JGBs, the yen could be vulnerable. A sudden yen plunge could have two immediate implications. 

One is the so-called “yen-carry trade” blowing up. Japanese rates at zero since 1999 turned Japan into the globe’s top creditor nation. For decades, investment funds borrowed cheaply in yen to bet on higher-yielding assets around the globe.

As such, sudden yen moves slam markets virtually everywhere. It became one of the globe’s most crowded trades, one uniquely prone to correction. Arif Husain, head of fixed income at T. Rowe Price, calls the yen-carry trade the “San Andreas fault of finance.”

Another: a weaker yen would surely provoke the ire of the Trump White House. The slightest suggestion Tokyo is manipulating exchange rates could have Trump threatening to increase the 15% tariff rate. Since the specifics of the US-Japan tariff arrangement aren’t written down on paper, Trump could always renege.

Tokyo worries a sliding yen would have Trump gunning for Ishiba. This could include Trump’s Treasury Department slapping the dreaded “currency manipulator” label on Tokyo.

This has Japanese officials anxious to manage the currency — and to keep the yen off the radar screen. The BOJ and Finance Minister Katsunobu Kato have so far managed to limit the yen’s downside.

Suspicions are rife that Trump is pressuring Treasury Secretary Bessent — a hedge fund veteran who presumably knows better than — to weaken the dollar. This goal is partly why Trump is prodding the Fed to slash borrowing costs.

Trump has threatened to fire Fed Chair Jerome Powell. He’s calling on Fed Governor Lisa Cook to resign and has his Justice Department investigating her. As Trump damages trust in the Fed’s independence one social media post at a time, the dollar’s troubles are mounting in real time.

Asia worries Trump will force Bessent to depreciate the dollar unilaterally, perhaps using currency intervention. Or perhaps even default on US debt. On the campaign trail last October, Trump said of Democrats: “I say to the Republicans out there – Congressmen, Senators – if they don’t give you massive cuts, you’re going to have to do a default.”

Trump’s dangerous flirtation with a default on US debt reared its head on the campaign trail in 2016. At the time, he told CNBC, “I would borrow, knowing that if the economy crashed, you could make a deal. And if the economy was good, it was good. So therefore, you can’t lose.”

In 2020, the Washington Post reported that the Trump White House mulled cancelling debt held by Beijing amid trade tensions. With the US national debt twice the size of Chinese GDP, it’s not hard to understand how much of a financial earthquake that would be.

Such debates play into China’s hands. To be sure, Xi’s Communist Party worries about Trump’s policies that damage the dollar. Along with putting China’s exports in harm’s way, Trump is helping make Beijing’s case for an alternative to the dollar.

A key Xi initiative has been to internationalize the yuan. The effort has made inroads. But Trump’s assault on the dollar’s global standing may accelerate the changing of the guard in currency circles.

All these risks have Asia waiting with bated breath for Powell’s speech on Friday. Powell will address the Fed’s annual retreat in Jackson Hole, Wyo., at a moment of maximum pressure on the central bank to cut rates.

“Some investors are concerned about rising US interest rates and falling US equity prices stemming from the Fed’s hawkish stance at the Jackson Hole Symposium, and the potential spillover to Japanese equities,” says Sho Nakazawa, economist at Morgan Stanley MUFG. “However, if higher US rates lead to a stronger dollar-yen rate, we think Japanese export-oriented value stocks could serve as a buffer in global equity portfolios.”

Still, Nakazawa says, “we think the market currently sees a September rate cut by the Fed as almost certain. If Chair Powell uses this week’s most closely watched event … to push back against rate cut expectations, the pricing in of near-term easing could unwind, leading to higher US interest rates and potentially negative implications for equities.”

And JGB yields. If JGB yields rose to 2% or 3%, banks, insurance companies, pension funds, endowments, the postal system and the growing ranks of retirees would suffer painful losses. The risks to the domestic economy – and household and business confidence – are rising with JGB yields in ways that could have global fallout.

Follow William Pesek on X at @WilliamPesek