Japanese Denial on Debt

Japan's long-term interest rates paint a picture of debt distress

Japan is in denial. For a long time, its long-term interest rates were very low despite its mountain of government debt, feeding the illusion that this was somehow normal. It wasn’t. Low yields were artificial and resulted from large-scale bond purchases and yield caps by the Bank of Japan (BoJ). This approach ran into trouble in the aftermath of COVID. Long-term government bond yields started rising globally as central banks hiked to ward off inflation. The BoJ continued capping long-term yields, but this sent the Yen into a devaluation spiral. Yield caps had become unsustainable.

The key thing to know about Japan’s long-term yields is that they’re still - even after their rise in recent years - artificially low. After all, as I noted in this post, the Bank of Japan (BoJ) remains a massive buyer of Japanese government debt on a gross basis. Just imagine how much higher Japanese yields would be if the BoJ were truly out of the market. Japan’s “shadow” long-term yield - the yield that would clear the market in the absence of BoJ bond buying - is much higher than what we observe.

The easiest way to see how massively distorted Japan’s long-term yields are is in the chart above. The horizontal axis shows gross debt in percent of GDP. The vertical axis shows 30-year government bond yields. Euro zone countries are in red, the rest of the G10 are in blue and Germany (DE) as well as Japan (JP) are in black. German debt in 2024 was 65 percent of GDP, while that of Japan was 240 percent. Yet both countries have the same 30-year government bond yield. That’s a sign of a massive mispricing in Japanese yields, which are way below where they should be.

Japan has a choice. It can either let markets set yields without BoJ interference. That will stabilize the Yen, but at the cost of far higher long-term yields and a debt crisis. Or it can cap yields, in which case the Yen will continue its slide. More debt-financed stimulus - which Sanae Takaichi hopes will differentiate her from her predecessor - will only make all this worse and is a sign that the highest levels of government don’t understand how precarious Japan’s debt situation is. It’s easier to stay deluded than acknowledge an unpleasant reality.