When the whole world is staring at US debt, Japan is storm?

Source: Wall Street News

While the world closely watched whether U.S. Treasuries would plummet due to Moody's downgrade, a real bond market collapse unfolded on the other side of the globe in Japan.

Japan's 20-year government bond saw its worst auction since 2012, with the bid-to-cover ratio plunging to 2.5 times and the auction tail surging to its highest level since 1987. This bond disaster has triggered the yield on Japan's 40-year government bond to break through a historical high, reaching 3.59%. As the Bank of Japan's (BOJ) quantitative tightening (QT) plan comes under scrutiny, investors must be wary of the chain reactions that global bond market volatility could trigger, particularly for institutional investors holding Japanese and U.S. bonds.

### Epic Collapse: Japan's Bond Auction Fiasco

The Japanese Ministry of Finance's auction of ¥1 trillion ($6.9 billion) in 20-year government bonds on Tuesday recorded a catastrophic result. The bid-to-cover ratio was only 2.5 times, far below the previous month's 2.96 times and the lowest level since 2012.

Even more shocking was the auction tail (the gap between the average price and the lowest accepted price), which soared from 0.34 in April to 1.14, the highest level since 1987.

As a "thermometer" for bond auctions, a larger auction tail indicates extremely weak market demand, with buyers largely unwilling to take on long-term government bonds. Investors are rejecting the current prices, raising risks.

This bond market fiasco immediately triggered a plunge in Japanese government bond futures. The yield on the benchmark 10-year bond surged to 1.525%, the highest level since late March; the yield on the 20-year bond rose 15 basis points to 2.611%, the highest level since 2000; the yield on the 30-year bond rose to the highest level since its launch in 1999; and the yield on the 40-year bond jumped 10 basis points to a record high of 3.591%.

Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management, said:

"The results were worse than I expected. 30-year and 40-year bonds have been sold off due to fiscal expansion risks and declining liquidity, but the deterioration in market conditions has now spread to the previously relatively stable 20-year bonds."

### BOJ's Quantitative Tightening Faces Severe Test

This auction disaster is a heavy blow to the BOJ.

The BOJ currently holds 52% of Japan's government bond market, making it the largest buyer of Japanese government bonds. But as the central bank begins to gradually reduce its massive bond holdings, a key question arises: Who will buy Japanese government bonds without the central bank's support?

According to media reports, the BOJ will consult with market participants this week to assess the progress of its QT plan.

Domestic political factors are also complicating the BOJ's decisions on QT policies. Japanese lawmakers are discussing whether tax cuts or increased fiscal spending are needed to ease the impact of high inflation on consumers. Japan's sales tax is likely to become a core issue in this summer's elections, testing Prime Minister Shigeru Ishiba's leadership.

Mari Iwashita, executive interest rate strategist at Nomura Securities, said:

"This is a significant event. When the BOJ makes its decision next month, it will not want to surprise the bond market, so it may send some subtle signals."

Since starting to reduce bond purchases in July last year, the BOJ's holdings of long-term government bonds have only decreased by 2.2%, to ¥576.6 trillion. The central bank previously said it plans to reduce bond purchases by ¥400 billion per quarter until monthly purchases fall to ¥2.9 trillion in the first quarter of 2026, down from ¥5.7 trillion in July 2024.

If the BOJ insists on cutting purchases by ¥400 billion per quarter, monthly purchases will fall to ¥1.3 trillion by 2027, far below the level before the large-scale easing program began in 2013.

However, faced with violent bond market volatility, the BOJ is now in a dilemma:

- Continuing with QT could further push up yields, causing huge paper losses for bond holders and potentially forcing the central bank to reinstate negative interest rates and yield curve control.

- Abandoning QT now, cutting rates to zero or negative, and recontrolling long-end yields through a new round of quantitative easing (QE) could lead to runaway inflation and a collapse in the yen.

### Shockwaves Beyond Japan

The turmoil in the Japanese bond market is not an isolated event, it may trigger a chain reaction in the global financial market. Japan's 40-year Treasury bond yield broke through 3.44%, a 20-year high, and this increase may lead to global financial shocks.

Japan has the world's highest debt-to-GDP ratio, exceeding 250%. When yields rise, the government's borrowing costs increase significantly, and the cost of servicing existing debt also soars. As the world's third-largest economy and a major bond market, pressure in Japan's bond market could trigger a rise in global borrowing costs.

Notably, Moody's downgraded the U.S. credit rating from Aaa to Aa1 on Friday, citing growing fiscal deficits and a "lack of effective policy measures." This downgrade further amplifies uncertainty in global bond markets, particularly for the two major debtor nations, the U.S. and Japan.

As the BOJ's policy meeting on June 16-17 approaches, the market will closely watch the central bank's decision on the pace of QT.

One fact that cannot be ignored is that Japan's bond market has never truly recovered its health, with the central bank's market function indicators consistently negative, and recently falling from -13 in February to -44 in May, reflecting excessive influence on pricing from changes in overseas trade policies.

For global investors, this Japanese bond market storm may only be the beginning of a broader financial restructuring.

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