Although yields on Japanese government bonds (JGBs) have been rising for some time, the recent sharp increase has accompanied concerns about fiscal sustainability and the riskiness of holding JGBs. What can we say about the drivers of the increase and the market narrative they imply?
To comprehensively assess the attractiveness of allocating to JGBs or other asset classes in Japan from either tactical or strategic perspective, investors need a comprehensive framework that accounts for all the effects jointly and gives a near-real time account of what the market is pricing.
Here, we break down movements in yields into long-term anchors of yields: long-horizon inflation expectations, and the long-term growth outlook, and less persistent yield drivers: real rate (monetary policy stance) expectations and term premiums. The latter two cyclical drivers account for the bulk of day-to-day variation in yields.
Long-horizon inflation expectations have been increasing steadily since 2020 in Japan, as shown in the chart below. Since April 2020, 10-year inflation expectations have increased from around 0.6% to around 1.8%.
This has been the main driver of a more gradual increase in yields over the past years, as shown in the chart below that decomposes the 10-year yield since 2020. The remaining part of the increase can be attributed to a steady increase in the term premium, reaching levels not seen for more than a decade.
The high level of term premium stands out in comparison with the other markets, where our estimates of for the US, UK, and Europe are either negative or close to zero. One way to interpret the increase in term premium for Japan is that it is a slower-burning version of the “Liz Truss” moment in the UK Gilt market in September 2022.
In this episode, which we wrote about in this Insights piece, a fiscally driven increase in the term premium caused a spike in yields. While this was short-lived, what followed was an upward trajectory in yields. This reflected expectations of real interest rates increasing as markets priced tighter monetary policy in the long-run to counter fiscally-driven inflation. Investors placing their bets on JGBs on the basis of high term premium need to contend with a scenario under which Bank of Japan is also forced to run a permanently tighter monetary policy to fight inflation and to attract the investors given the fragile fiscal situation.
In this scenario, similar to the UK, investors wouldn’t be able to rely on currency appreciation from higher rates to help returns either. These episodes tend to be accompanied with higher risk pricing attached to currencies – as demonstrated by the recent depreciation in the Japanese Yen, and the relatively sideways movement in sterling FX in the years following 2022.
The rapid increase in yields did not prevent Japanese equities from delivering stellar returns, outperforming most of the major equity indices. In addition to the steadily improving earnings outlook (corporate reforms and currency weakness), the compression in the equity risk premium has largely absorbed the increase in yields. This is similar to what happened in other major equity markets, see more on this in our previous Insights piece.