Japan reveals the sun is setting on old world debt economics

That price, for IOUs issued in the world’s third largest economy, has huge implications well beyond its shores. For decades low interest rates in Japan, subdued inflation, alongside huge volumes of public debt - now approaching $9 trillion - has meant Japan has been a siphon of capital for other nations. Japan’s ability to do this alongside running up huge debt levels - worth more than 2.5 times the size of its own economy - without collapsing the price of its debt has emboldened other nations to run large debt positions. The “Japan Experiment” is unravelling fast. The price of Japanese debt, so key to the world economy, is now sinking fast.

Since late 2019 the price of 30-year Japanese government debt has fallen by almost half - leaving investors, and the Bank of Japan, nursing multi-trillion Yen paper losses. The flip side of these losses has been the interest rate on 30-year Japanese debt has risen to almost 3%, having been as low as 0.2% pre-pandemic. Whilst the Bank of Japan are not forced sellers of this debt, such liabilities sitting on balance sheets of any institution should trigger alarm bells.

And it is the international ramifications of what is going on in Japan that makes the price of its debt so important for the world economy. For years Western governments have benefited from Japanese investors hunting for higher interest rates across the world. The US government has more than $1.1trillion of its national debt held in Japanese hands, making Japan the largest international creditor for the US. With better yields now available in their home market, Japanese investors are in a position to demand higher carry for the privilege. The result has contributed to interest rates on US long bonds to approach 5%. Similar interest rates are now facing the UK government. Even the fiscally conservative Germans must now pay more than 3% to issue 30-year debt for the first time since 2010.

One encouraging interpretation is that these are healthy price signals from bond markets warning policymakers on the unsustainability of current and projected debt. Global debt levels grew to more than $320 trillion by the end of 2024, and shows few signs of slowing down. Having seen interest rates on this debt suppressed by more than a decade of central bank activism - including Quantitative Easing, where the Bank of Japan has been the biggest contributor – a reduction in central bank ownership of debt is reasserting a more efficient prices to debtors in the public and private sectors.

But efficient prices are not necessarily comfortable prices. For governments in Japan, the UK, France, and the US that run large deficits this is challenging the wisdom of paying for public spending through sustained borrowing, and deferring the cost of that spending onto future generations. The era of issuing long dated debt at favorable interest rates and deferring difficult decisions on delivering a sustainable level of spending looks to be shuddering to a halt.

There are three big implications of this shift. The first is a reassessment of how much long-dated debt businesses and governments will find it attractive to issue. The post financial crisis era incentivized company finance directors, households and governments to fix their interest rates for long durations. Iconically amongst this period was the Austrian government which in both 2017 and 2020 issued 100-year debt at near zero interest rates. Whilst these debt issues have been a lousy investment, they provided certainty for Austrian taxpayers. The advantages of this certainty are disappearing into the rear view mirror and with it the ability to make long term public spending decisions with confidence over the cost of financing. Issuance of more short term debt has recently increased as debtors judge they will wait for inflation to moderate, and creditors to show greater willingness to lock their money away for long periods.

The second implication is for the policy rates set by central banks. There continues to be considerable debate on where the equilibrium interest rate sits across a range of economies. For most developed economies this is assumed to be in the 2% to 4% range. But how owners of debt perceive the inflation risk, the policy risk, the attractions of other investment options like equity, and alternatives such as gold and crypto assets all shape the financing conditions facing the wider economy. It is likely that events in Japan, where inflation is taking hold in a way that hasn’t been seen for two decades, as well as events in the US where tariffs not seen in 100 years are on the table, introduce higher term premia for debt. These term premia are the additional interest rates that investors demand for locking their money away for long periods. All else being equal this puts pressure on central banks to bring down the cost of borrowing at shorter durations where the their policies have more control. It also impacts the wisdom of selling debt or reinvesting maturing debt as central banks reduce their holdings of government paper. Last month the Bank of England swapped a sale of its long duration debt for shorter duration sales. This provided a clear signal of the pressure caused by high long term interest rates.

Thirdly, this all risks becoming very political, very quickly. And investors appear to know this. President Trump’s chair of the Council of Economic Advisers, Stephen Miran, authored a paper last year suggesting that countries that didn’t engage with the Trump administration on tariffs, security guarantees, and issues of currency manipulation would face having their holdings of US government debt converted into zero interest rate paper. This looks, and smells a lot like a sovereign default. There is perhaps little surprise therefore that Japan as a country possessing a big trade surplus with the US and with an explicit security guarantee since 1960 would be seen as one of the countries most impacted. A higher default premium on global debt as this rebalancing of geopolitics evolves is a rational, if painful, response.

The bond market continues to tell the richest stories about where modern economies are heading. The Land of the Rising Sun continues to point to a sunset of the debt economics that modern economies have grown to rely on.