What the collapse in JGB liquidity means

Liquidity dried up in JGBs because of the Prime Minister's comment on ending austerity

There’s a lot of nonsense that that gets said on trading floors. Some of the worst revolves around “liquidity” and “positioning.” When people start talking about this stuff - often having adopted a Yoda-like expression - all they’re really saying is: “The price went down because supply was greater than demand.” There’s absolutely nothing profound about this, which is why I usually head for the hills when these words come up.

This week’s JGB sell-off is a case in point. I’ve now seen countless stories that the sell-off was due to poor liquidity. This is nonsense. What happened is that Prime Minister Takaichi called elections and is running on an end to “excessive” fiscal austerity. This - understandably - caused markets to ratchet up their probability Japan is heading for a serious fiscal crisis. As a result, buyers of JGBs evaporated and liquidity deteriorated. Thin liquidity in this context is really just another way of saying that supply exceeded demand. That’s an inane statement. The interesting question is why that happened, which is of course that Japan remains in deep denial over its debt.

The chart above shows Bloomberg’s bond market liquidity index for a selection of advanced countries. Let’s be clear about what this thing is first of all. Ideally, the yield curve is perfectly smooth as you go from short to longer maturities. In practice, it can happen that the yield on adjacent maturities is very different, which - intuitively - is a decent signal that bond market liquidity is poor. The Bloomberg liquidity index sums up the absolute value of these kinks in the yield curve, so that a higher value may be a signal that liquidity is poor. This in no way is a perfect signal. It’s given false positives on a number of occasions, most notably for the US in 2024. But - overall - I think this is a useful measure and I look at it regularly.

The chart shows that Japan’s index has shot up in recent days and is now the highest across key advanced economies. What’s important to notice is that the spike in this index coincided with Prime Minister Takaichi calling elections and saying she wants to end “excessive” fiscal austerity. Markets - understandably - want to be paid a higher risk premium to hold Japanese public debt after such a comment. Because the Bank of Japan remains a large buyer of JGBs, yields weren’t able to rise enough to compensate potential buyers for the perceived greater risk of default. This is why liquidity dried up and remains difficult. Nothing about this is irrational or a market failure that warrants intervention. The only thing needed is a change in policy to - finally - bring public debt down in a serious way.