Macro Signposts | 3 June 2025

This week, I asked Tomoya Masanao, co-head of Asia-Pacific portfolio management, Ryota Kawai, portfolio manager, and Allison Boxer, economist, to guest author Macro Signposts, sharing insights on recent volatility in Japan's government bond markets.

Japan: Rates and Risks Back on the Global Stage

By Allison Boxer, Tomoya Masanao, and Ryota Kawai

Japan's interest rates returned to the spotlight in May as 30-year government bond (JGB) yields climbed above 3%, the highest level in more than 25 years. This coincided with a pronounced steepening of the JGB yield curve, with the 5-year to 30-year spread briefly exceeding 200 basis points - one of the steepest curves among major developed markets and nearly twice as steep as the comparable U.S. Treasury curve. For foreign investors accustomed to the pre-pandemic era of low or negative yields on JGBs, the current environment is striking: 30-year JGBs hedged to the U.S. dollar now yield over 7%.

Since March 2024, Japan's economy and investors have been recalibrating to a new reality following the country's exit from a prolonged phase of extraordinary monetary policy accommodation. This has resulted in higher interest rate volatility, including the recent long-end JGB sell-off, which in turn has reignited questions about the sustainability of Japan's fiscal position - the nation's debt-to-GDP ratio has long exceeded 200%.

Although fiscal challenges persist - and are likely to get somewhat worse - we believe the recent volatility reflects some idiosyncrasies about JGB markets that are turning the long end of the yield curve into a release valve for interest rate volatility. As a result, we think global investors should be evaluating long-end JGBs in the context of rising global term premia overall, as opposed to in isolation. Interest rate risk in Japan may indeed be a component of an attractive allocation to duration globally - a significant change from the pre-pandemic decade.

JGB curve reflects unique supply/demand dynamics
Following the Bank of Japan's exit from its decade-long regime of negative rates and yield curve control in March 2024, the central bank has hiked rates two additional times and begun to shrink its balance sheet.

In a May 2024 edition of Macro Signposts, we argued that "moving from a generally stable state of low rates and inflation to an economy of 2% inflation could also uncover vulnerabilities that increase volatility."

Indeed, high interest rates and volatile markets have brought Japan's fiscal vulnerability back into focus. At over 230%, Japan has the highest central government debt-to-GDP ratio across developed market (DM) economies, far surpassing Italy (nearly 140%) and the U.S. (120%), according to the International Monetary Fund (IMF). In the past, Japan's low and stable interest rates - despite elevated debt levels - have made it the centerpiece of arguments, especially for the U.S., that high and rising government debt on its own is not necessarily a cause for concern.

Does the recent sell-off of Japanese long-term interest rates suggest the world's fifth-largest economy has reached a debt level that is no longer sustainable - possibly portending problems ahead for other DMs?

We believe it's important to note that while deterioration in supply and demand because of high debt levels is often cited as the key driver of volatility in the JGB market, much of the recent volatility appears to be driven by technical factors - including the Bank of Japan (BOJ) reducing JGB purchases and changes to the JGB investor base - and does not reflect increased JGB issuance. Bond issuance increased significantly in Japan during the pandemic, much as it did in other DMs. However, in contrast to the U.S. in particular, JGB issuance has been decreasing in the past few years, albeit slowly. Fiscal deficits have actually declined (improved) somewhat in Japan since the pandemic, according to IMF data. In addition, Japan differentiates itself with a large net international investment position (NIIP) of nearly 90% of its nominal GDP in 2024.

Our view is that the JGB market is experiencing a structural imbalance in supply and demand that's unique to the Japanese yield curve for a couple of reasons:

• Life insurers (known as lifers), a long-time source of demand for long-term JGBs, are no longer structural buyers. They have generally covered their asset-liability management (ALM) gap and recently have been net sellers as yields have risen.
• As we highlighted last year, although gross government debt-to-GDP is over 230%, the consolidated balance sheet includes the BOJ's holdings of JGBs - equivalent to roughly 100% of GDP. The BOJ owns over 50% of outstanding JGBs with maturities below 10 years, including 90+% of some issues. Given the BOJ's dominant footprint in shorter-dated bonds, long-end rates have become the release valve.

Japan's policymakers have tools ...
We think policymakers can - and likely will - do more to help address the supply/demand imbalances in JGB markets:

• The Ministry of Finance (MOF) could more actively manage debt issuance at shorter (perhaps quarterly) intervals, seeking to nimbly balance policy between "predictability" and "flexibility." Currently, the MOF fixes its issuance plan annually, setting not only total amounts but also issue maturity distribution and each issue amount (versus the U.S. Treasury's quarterly refunding, for example).
• The BOJ can continue to reduce its footprint in JGB markets via quantitative tightening (QT). We believe, somewhat counterintuitively, that this move could help improve supply/demand imbalances, and that QT could continue or even accelerate at some stage. As mentioned above, the BOJ's share of shorter-dated JGBs has made the long end an escape valve for any rise in the term premium (i.e., the compensation investors receive for taking on interest rate risk), exacerbating the long-end yield rise. If the BOJ continues to reduce its JGB holdings, typical market mechanisms could return to the rest of the yield curve.

... but risks and uncertainties remain
We believe Japan's policymakers are likely to act in an effort to prevent this period of volatility from becoming a more systemic problem. As we wrote last year, there is a risk scenario where investors demand even higher term premiums to the point of compounding vulnerabilities for public finances and financial stability risks.

This is also happening while fiscal policy and debt levels are in focus globally. Indeed, earlier this year we saw a steepening of Germany's yield curve after additional defense spending was announced, and in the U.S. Treasury curve as Congress moved forward a bill proposing additional tax cuts.

In Japan, we think additional modest fiscal easing is likely as a response to the U.S.-tariff-driven demand shock (and pressure on global defense spending). Easing would need to be well-targeted and coordinated with debt management in order to limit an excess rise in the fiscal risk premium.

For policymakers facing fiscal concerns coinciding with structural market challenges, active debt management may be more important than ever, especially given the rise of global competition for investor interest amid steadily increasing global sovereign debt issuance.

Investment implications
For global investors, the recent movements in JGB markets are a reminder that a period of heightened macro volatility and uncertainty also can create opportunities. Unlike the era of low- or negative-yielding debt before the pandemic, investors can now diversify across global fixed income markets and seek to benefit from attractive starting yields. While higher volatility is likely to continue, we believe that JGB valuations could be attractive for foreign investors seeking yield and diversification in global fixed income.

Catch up on recent editions of Macro Signposts:

• The U.S. Current Account: Trade and Fiscal Deficits Are Closely Linked | 28 May 2025
• Moody's Downgrade Underscores Tensions Over U.S. Debt Outlook | 21 May 2025
• How Does the Data Make You Feel? | 13 May 2025
• Tariff Tensions and the Fed's Policy Puzzle | 6 May 2025
• A Tariff Winter Is Coming? | 30 April 2025

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