Goldman Sachs believes that although the current sell-off in Japanese government bonds has not yet spilled over into the Japanese stock market or foreign exchange market, its spillover effect on the global bond market has become increasingly significant. Since the beginning of this year, 30-year Japanese bonds have contributed approximately 80 basis points of upward pressure on the yields of G4 countries, becoming the largest source of bearish momentum.
This implies that the recent surge in U.S. Treasury yields is likely largely a byproduct of the turmoil in the Japanese long-term bond market. This week, the most eye-catching event in the global bond market was not the surge in U.S. Treasuries, but the violent fluctuations in the Japanese government bond market. According to the latest research report from Goldman Sachs, the ‘collapse-style’ rise in Japanese long-term bond yields is the hidden force behind the sharp drop in U. S. Treasuries. On the 24th, according to Baidu News, Goldman Sachs believes that the core reason for the surge in Japanese long-term bond yields is a severe supply-demand imbalance. The demand from life insurance companies has plummeted due to the widening duration gap, coupled with increased fiscal concerns from the government and the selling triggered by asset-intensive reinsurance transactions, which together have built up selling pressure in the long-term bond market. These factors have led to a scarcity of buyers in the Japanese government bond market and extremely poor liquidity, even with the Bank of Japan holding a large amount of government bonds. Goldman Sachs also emphasizes that although the sell-off in Japanese government bonds has not yet spilled over into the Japanese stock market or foreign exchange market, its spillover effect on the global bond market has become increasingly significant. Data shows that since the beginning of this year, 30-year Japanese government bonds have contributed approximately 80 basis points of upward pressure on the yields of G4 countries (U.S., Europe, Japan, and the UK), becoming the largest source of bearish momentum. This implies that the recent surge in U.S. Treasury yields is likely largely a byproduct of the turmoil in the Japanese long-term bond market. Looking ahead, the volatility in the Japanese government bond market is expected to continue. Although the Japanese government may consider reducing the issuance of long-term bonds or repurchasing them, Goldman Sachs believes that without substantial macroeconomic policy responses to high inflation, such volatility will recur. The direction of the Bank of Japan’s monetary policy, especially its adjustment of the quantitative tightening path, will be key to influencing market trends in the short term. Why has the yield on Japanese long-term bonds surged? Goldman Sachs Japan interest rate trader Yusuke Ochi points out that the recent sharp rise in Japanese long-term bond yields is mainly due to a significant deterioration in the supply-demand balance, including changes in demand from life insurance companies and the tightening of duration gaps, and this trend is not a short-term phenomenon. Insufficient demand from life insurance companies: The duration gap of life insurance companies is already in the negative territory (-1. 5 years as of September 2024), making it difficult to sustain demand for long-term government bonds. Especially for 40-year bonds, the liability discount curve under the new solvency rules makes their natural buyers scarce.Additionally, some buyers have transformed into net sellers of Japanese government bonds, leading to an extremely pessimistic supply and demand outlook.
Escalating fiscal concerns: As the Senate elections approach, almost all opposition parties are calling for a reduction in consumption tax. If the ruling Liberal Democratic Party suffers a significant defeat, concerns about Japan’s fiscal prospects will intensify markedly. Should this lead to a downgrade in Japanese government bond ratings, the demand for long-term bonds may further deteriorate. Impact of asset-intensive reinsurance: After October 2023, a series of large asset-intensive reinsurance transactions were announced. In this business model, reinsurers take over the assets and liabilities of Japanese life insurance companies and replace assets with higher-yielding products to earn a spread. In this process, Japanese government bonds are often sold, negatively affecting the supply and demand balance of long-term bonds. Market technical factors and positioning bias: Goldman Sachs Japan interest rate strategist Bill Zu noted in a report that the current yield level of 30-year Japanese government bonds is now comparable to that of 30-year German government bonds, a situation that rarely persists outside the effective lower bound period. This selling has been relatively concentrated in long-term bonds, leading to a steeper slope of the 10-year and 30-year yield spread than its usual relationship with absolute yield levels. Meanwhile, Goldman Sachs’ measure of the 10-year term premium has not risen significantly, and the changes in 2-year, 5-year, and 10-year yields are far less than their average relationship with the 30-year yield. The selling has been exacerbated by technical and positioning factors, including leverage flattening positions and extremely poor liquidity in demand for long-term bonds. This is largely related to the Bank of Japan holding 52% of the Japanese government bond market. It is worth noting that, so far, the selling of 30-year bonds has not been accompanied by broader portfolio pressure on other Japanese assets, such as stocks or currency, which contrasts sharply with the US market. In the US, bond selling is usually accompanied by a weakening of the stock market and the dollar. This decoupling may suggest that the local weakness of Japanese 30-year bonds may be temporary and could even reverse if technical and positioning tensions ease. The fundamental cause of inflation and supply-demand imbalance: Goldman Sachs believes that the fundamental cause of this round of volatility is the persistent rise in inflation rates, coupled with the aforementioned worsening supply-demand imbalance due to the decline in duration demand and the government’s continued massive financing needs. Unexpected Japanese inflation: Japan’s inflation has been stronger than expected, partly due to the soaring rice/food prices that the Bank of Japan cannot control. Forward inflation expectations have risen to cyclical peaks, leading to a continuous repricing of equilibrium yields. Reduced demand from ALM accounts: Similar to other countries, the surge in Japanese yields has led to a reduction in duration demand from ALM accounts, as liabilities shrink due to rising interest rates.Overseas investors show a lack of interest in Japanese government bonds: Monthly transaction data from the Japan Securities Dealers Association (JSDA) indicates that domestic long-term bond holdings have stabilized, intensifying concerns about the absorption of long-term bond supply, especially with the increase in long-duration supply. This is reflected in the recent astonishing weakness of long-term government bond auctions, including the tail of the 20-year government bond auction reaching the worst level since 1987. This suggests that the claim that Japanese investors are not purchasing U.S. Treasury bonds and instead buying a large amount of Japanese duration bonds is false.
Global spillover effects: Japanese bonds dragging down U.S. bonds Goldman Sachs points out that the spillover risks of rising Japanese interest rates to the global bond market are a frequently raised question by clients. Current evidence is mixed. On one hand, Goldman Sachs believes that technical factors are the main cause of fluctuations in Japanese long-term government bonds, which may imply limited impact on other markets. Additionally, the common factor of G4 yields (the first principal component) explains a small portion of the total variance of the long-term curve (such as 10-year to 20-year), indicating that movements in long-term yields are more idiosyncratic. On the other hand, there is more evidence showing that Japanese long-term government bonds are beginning to exert greater pressure on global long-term yields. Goldman Sachs’ variance decomposition model shows that since the beginning of this year, 30-year Japanese government bonds have contributed about 80 basis points of upward pressure to G4 yields, being the largest source of bearish forces within the G4. Almost all of this has occurred after April 2nd, which may reflect poor liquidity conditions, cautious risk-taking, and intensified fiscal concerns (also evident in other G4 markets). This means that much of the recent selling pressure on U.S. Treasury bonds is not actually due to domestic U.S. factors, but rather a byproduct of Japan’s clearing of back-end positions. Investors face ongoing volatility risks Amid ongoing bond market turmoil, the Japanese Ministry of Finance may consider reducing the issuance of 30-year and 40-year government bonds, or even repurchasing non-current bonds. However, historical experience shows that proactive fiscal tightening has never truly occurred without a market crisis forcing it, as it would be tantamount to political suicide for the ruling party. A more likely catalyst is a decision by the Bank of Japan on monetary policy, including any adjustments to the quantitative tightening path. Goldman Sachs economists maintain their view that the next rate hike will be in January 2026, with the terminal interest rate potentially reaching 1.5% in the distant future. Before that, Goldman Sachs continues to forecast upward pressure on 5-year and 10-year interest rates, with these two curve points performing weaker than 30-year Japanese government bonds over the next 12 months. Goldman Sachs analysts admit that how to resolve the current volatility in Japanese government bonds remains unclear.Considering the macro-driven factors prevalent in major bond markets, such as high inflation and substantial bond supply, the repricing process has been quite drastic. The longer it persists, the more destructive it becomes to both domestic and international markets. As summarized by Zu from Goldman Sachs: “The wildfire of 30-year Japanese government bonds may stem from local weather conditions, but the adverse climate for duration assets foreshadows ongoing volatility in the global curve.”
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