On Tuesday, Wall Street traders confronted an even bigger fear than political chaos in Washington: the Japanese bond market.
The problem was a shockingly weak demand for Tokyo’s debt at a government auction. A day earlier, the Bank of Japan announced that it might curb its own purchases of debt – purchases aimed at reviving a lethargic economy.
Twenty-four hours later, bond punters let the BOJ know that they expect it to keep buying truckloads of debt.
Where are the buyers?
Too few buyers showed up at Tokyo’s sale of nearly US$20 billion of 10-year securities. The ratio of bids to the amount of bonds on sale dropped to 3.42 from 3.60 in September.
That, Reuters says, was the weakest outcome since March 2015. It is also a sign that the BOJ can’t withdraw from the market as it hoped to.
It was weak enough to send US Treasury yields up by 8 basis points, a significant signal as these things go. Investors were reminded the same thing could happen in the US, sparking a sell-off. The same with European sovereign debt.
Wall Street stock traders also were buzzing about events 7,000 miles away and what they portend for global stability.
The reasons for this are many. Japan is the developed world’s most indebted nation as a proportion to gross domestic product, with more than $10 trillion of government IOUs in circulation. Naturally, any trouble in the third-biggest economy will spread fast.
Also, the yen is considered as safe an asset as you’ll find amid the global trade war. Any whiff of turmoil in Tokyo upends calm in currency circles.
But there are a couple of bigger issues at play. Bond dramas in Japan could quickly hit the US, where Donald Trump is mortgaging America’s future like one of his failed casinos. In less than three years as president, he boosted Washington’s debt to $22 trillion and annual $1 billion deficits as far as the eye can see.
Some countries are too big to fail. Others are too big to save.
The Tokyo debt trap
The other consideration is Tokyo’s own solvency. Japan’s auction fail came the same day a sales tax rose to 10% from 8%. In recent months, Prime Minister Shinzo Abe had come under pressure to scrap this long-mooted increase as the economy slows.
But Abe pushed ahead to prove Tokyo’s determination to pay down debt with the proceeds. That bold move may have been a bad one. Weak demand for 10-year bonds suggests traders doubt Japan can curtail its borrowing addiction.
The distrust is understandable because Abe’s play may, in fact, have the opposite effect of what was intended.
In 2014, Abe’s government boosted sales tax to 8% from 5%. The resulting recession had Tokyo increasing borrowing to offset the fallout from a tax hike that was meant to reduce debt. By the end of 2018, Tokyo’s debt had increased by nearly the same amount, in percentage terms, as that 3 percentage-point tax bump.
Bond punters appear to fear a similar outcome this time. Their reaction on Tuesday means that, at a minimum, the BOJ won’t be withdrawing from Japan’s bond market anytime soon.
Since 2013, Governor Haruhiko Kuroda and his team hoarded more than half of outstanding debt. While that largess has deadened bond-trading dynamics, it also spared investors sudden spikes in yields.
Bottom line? The BOJ is trapped.
Investors, not so much. If punters decide Japanese government debt – or the yen – is less attractive, yields could march higher. That might not seem like an urgent concern given that 10-year rates are 0.17%. But any increase raises two immediate risks and a third of a longer-term nature.
Here comes the risk
One: Tokyo’s credit rating. The reason Moody’s, Standard & Poor’s and Fitch Ratings aren’t warning about Japan’s debt load is that it’s almost cost-free at the moment. Those holding Japanese debt are practically paying for the honor of holding Tokyo’s IOUs. That calculus changes fast as Tokyo’s financing burden grows thanks to higher yields.
Two: the fact that virtually every corner of Japan Inc is in harm’s way. Government debt is the chief financial asset held by banks, local governments, pension funds, insurance companies, endowments, universities, the postal system and one of the globe’s fastest-growing populations of retirees. A jump in rates even to 2% would have far-reaching and unpredictable effects.
That’s true globally, too, of course. In September, the amount of corporate issuances in a single month across the globe topped $300 billion for the first time, Bloomberg reports. Turmoil in the government debt benchmarks on which those corporate issues are priced would amplify the shockwaves.
Three: the lessons for other regions, most significantly Europe. While the Federal Reserve is cutting rates, it did manage to get borrowing costs more than 200 basis points above zero. Europe, like Japan, is still stuck at zero and beyond. Yet these bond-buying safety nets can be dangerous.
At the very least, they breed complacency. Europe’s quantitative-easing scheme won’t make countries or companies more competitive, innovative or productive. Monetary authorities get trapped, too.
Just ask the BOJ, which has been stuck at zero since 1999.
If the European Central bank tried to withdraw from markets, yields in Germany, France and Italy are sure to skyrocket. That has left the ECB on the central-banking version of a treadmill.
Twenty years on, Kuroda’s team can’t even trim bond purchases without spooking markets from Tokyo to New York. Tuesday’s auction snafu highlighted the stakes for investors everywhere – stakes that are rising at this very moment.