Japanese Prime Minister Sanae Takaichi’s plans to boost spending and cut taxes spooked bond markets, on worries that Japan’s government debt will expand. The 10-year Japanese Government Bond yield jumped 26 basis points to 2.33% this year through Jan. 20, sparking broader market concerns.
Why it matters: The Japanese government has benefited from low interest rates, averaging around 0.33% between 2016 and 2025. With the 10-year JGB yield now at over 2.2%, interest costs will rise significantly as the existing JPY 1,287 trillion of debt is refinanced over the next 9-10 years.
Based on our sensitivity study, we estimate that Japan’s interest servicing will rise from 9% of total expenditure to 20%-25% if JGBs are refinanced at an average of 2.0%-2.5% over the next nine years. We assume that revenue will grow at 3%, which factors in 1% GDP growth, 2% inflation, and non-debt expenditure being neutral, growing also at 3%.This could lift total debt service expense to 35%-40% of total expenditure. It seems unlikely that the government can keep debt service to the current 25% level of total expenditure without significantly higher revenue to cap debt issuance in the next decade. Takaichi has mentioned that she is looking to keep the percentage of debt stable, so this implies higher revenue.
While there are countries with high debt, interest servicing constituting 20%-25% of total expenditure would be high for an OECD member with an investment-grade bond rating. OECD members’ interest payments as a percentage of total expense peaked in 1988 at 11.3%, during the period of high inflation and interest rates, which led to a global recession in 1989.
The Bottom Line: We have a neutral view of Japanese equities at the moment, with most stocks fairly valued (please refer to our first-quarter Asia market outlook). Should the market correct further on the JGB worries, we look forward to buying opportunities. We are not concerned with the 10-year JGB yield rising to 3%. We think this would be normal with the assumption for 1% GDP growth and 2% inflation.
We see the risk for continued JGB pressure to spillover into Japanese equities. The Morningstar Japan TME Index gained 7.9% this year through Jan. 14, before pulling back 3.6% since then. The JGB jitters, coupled with recent talks of intervention to support the yen, have pressured Japanese equities.
Japanese equities have had an inverse relationship with the yen, due to the conversion impact on export and ex-Japan source earnings. We see this as a neutral factor for shareholders, although some may be inclined to hedge currency bets.We keep a neutral view of the yen and expect it to hover around the JPY 150 level. The potential convergence of US treasury and JGB yields should ultimately provide some support to the currency. Our US economist expects US 10-year Treasuries to yield around 3.3% by 2028 as inflation pressure and monetary policy normalize in the United States. However, this doesn’t mean the yen will not see pressure in the near term due to risk worries over higher debt.We think the main risk remains with higher debt costs, as well as possible support to the bond market through asking financial institutions to help purchase bonds. While we don’t think this impacts the earnings of the banks and insurers, the move may be seen to be an unpopular use of capital in the short term.
Coming Up: The JGB market has settled down a bit after government assurances and possible Bank of Japan support. While we would not be surprised to see the BoJ step in to stabilize the JGB market, this feeds into inflation risks. The BoJ is expected to raise policy rates to around 1.25%-1.50% from the current 0.75% through 2028.
With Japan’s snap election on Feb. 8, we don’t expect Takaichi to back down on her plan to remove the 8% sales tax on food, with the key voter concern being deteriorating affordability.
Bulls Say: Unemployment is low and wages are expected to rise, which could help raise tax revenue for the government. Other possible sources of tax revenue include added stamp duties on real estate purchases by non-Japanese citizens. There could also be targeted removals of some tax breaks.
Demand for JGBs should settle down, and with yields adjusting to reflect normalizing policy, demand from Japanese institutions and the public should not be dampened over the mid-to-long term.
Bears Say: Although some measures, such as tax increases or spending cuts, will be implemented during this period to curb the rising ratio, the increase in social security costs will put pressure on spending and prevent a significant reduction in the amount of government bonds issued.
AloJapan.com