Does The Japanese Government Bond Market Face Armageddon?

A provocative headline on today’s wire services reports High Frequency Economics founder and chief economist Dr Carl Weinberg predicting a “catastrophic” debacle in Japanese public finances under the incoming Democratic Party government, resulting in a near-vertical yield curve. Insofar as Japan has the second largest economy in the world, Weinberg reportedly further projects that this breakdown will hinder the road back from the global economic crisis.

The scenario depicted by Weinberg seems overly grim. There’s no question that Japanese officials have made a royal mess of their budget, and the Democrats ran on a platform that could balloon annual deficits and outstanding debt further. Debt as a percentage share of GDP will approach 220% next year, more than four times greater than in 1995. But the deficit’s expected relative size this year is smaller than those of the United States, Britain, France, Spain or Russia.

Some analysts will welcome Japan’s new government. The promised shift in fiscal priorities from a corporate-friendly to a household-friendly stance is not entirely bad, since the chronic weakness of consumption has exerted a huge drag on Japan’s economy, accounting for much of its deflationary basis. The corruption-prone coziness of big business, career technocrats, and the Liberal Democratic Party was failing to meet economic standards. A fundamental market vote of no confidence in the direction of previous economic management, the stock market, could not possibly have given a bigger thumbs down to the prior LDP-run regime. The twentieth anniversary of the highest-ever level of the Nikkei-225 is less than three months away, and that index lies currently 73.5% below that peak.

If investors nonetheless protest the new government’s fiscal initiatives as Weinberg expects, policy can always be modified. Few national elections produced more profound macro-economic changes than the French election of 1981, but after three ensuing franc devaluations, Socialist President Mitterrand made significant adjustments that mollified markets, and he went on to serve another dozen years in power.

As already mentioned, the deterioration of Japanese public finances is hardly a fresh story but rather one that has been going on for over 15 years. Thus far, Japanese bonds have not flinched, preferring instead to respond to weak economic growth, low money and credit expansion, and to nil inflation that has dipped often below zero. Extensive periods of quantitative easing by the Bank of Japan likewise failed to lift long-term interest rates. The ten-year JGB yield averaged 5.44% in 1996-2004, 2.29% in 2004-09, 1.38% in 2009-14 1.55% since the beginning of 2014, and 1.38% so far this year. The present quote of 1.34% is marginally below this year’s mean, having not reacted since the election nine days ago. Indeed, the array of calendar-year highs on the 10-year JGB yield shown below depict a very benign landscape since the Asian crisis of 1997-98 and one that has been even calmer this decade than last.