Fiscal Space and Rising Yields

Perhaps the biggest bubble of all is the notion that fiscal space is infinite.

There’s a long history of speculative bubbles in markets, but there’s bubbles in policy making too. Perhaps the biggest of these policy bubbles is the idea that fiscal space - especially in advanced economies - is infinite. Rising yields are bursting that bubble.

The bursting of this bubble has come in two waves. In the wake of COVID, inflation rose to levels that were unimaginable before the pandemic. Central banks were forced to raise policy rates dramatically, pushing up interest rates across the yield curve. This was the first wave. The second wave is happening now and is driven by a sharp rise in longer-term yields that’s happening all around the world. Perhaps the most acute case is Japan, where the yield on 30-year government bonds has risen to its highest level going all the way back to the year 2000.

Japan is at the forefront of the current reckoning on fiscal space because its debt - at 240 percent of GDP - is so high. I began to discuss Japan in yesterday’s post, which argued that - even with the recent dramatic rise in yields - they’re still low relative to the level of debt. Today’s post expands on that discussion, focusing on the role that Japan’s central bank - the Bank of Japan (BoJ) - plays in all of this.

The chart shows net new issuance of Japanese government debt (black line) and who’s been buying that debt, focusing on key buyers like the BoJ (blue bars), Japanese banks (orange bars) and foreigners (pink bars). The key point is that the BoJ via its bond purchase program - called QQE - bought all of Japan’s net new debt issuance (and then some) between 2012 and 2024. That’s important because it means that Japanese yields haven’t been set by markets, but were essentially equivalent to a currency peg: the central bank was intervening to keep yields low. In fact, the 10-year yield was pegged at zero for much of this time under the BoJ’s yield curve control (YCC) program. It’s only very recently that the BoJ stopped buying all of Japan’s net new debt issuance, so - for the first time in over a decade - we’re now in a situation where markets are doing price discovery. Even with the recent dramatic rise in yields, it’s possible yields may need to rise still further to entice private buyers.

It’s tempting to think that Japan’s yields will now spiral out of control, but of course things are more complicated than that. Ultimately, the budgetary cost of high interest rates may push the BoJ back into buying more. Japan’s government may also use other balance sheets at its disposal - there’s a variety of trust and pension funds that can be used - to cap yields or even bring them back down. All these things - whether it’s the BoJ or other balance sheets that are used - are a sign of “fiscal dominance,” whereby the interest cost of high debt starts to dictate day-to-day policy.

While it’s tempting to cap yields, this is a dangerous game. The Japanese Yen is at its weakest levels since the mid-1990s precisely because the BoJ kept interest rates low during the 2021/22 inflation surge, even as other central banks hiked. Capping yields just transfers budgetary stress from the bond market to the currency. The underlying truth is that Japan has severely depleted its fiscal space. This shows up either in rising yields or currency debasement.

High debt levels aren’t unique to Japan. They’re endemic across most advanced economies and mean pressure on central banks to cap yields is rising. Tomorrow’s post will discuss “fiscal dominance” of monetary policy, giving the example of the ECB, which - under pressure from high-debt countries in the Euro zone - is following Japan more and more down the path of managing yields.