The Japanese Long End: Bonds Are Boring, Until They're Not

Intro

Back in May I wrote about Japan as a new market on eToro, and flagged currency risk as the single biggest downside to investing there. Three months later, that risk has grown into something much more substantial than I anticipated.

Japan's bond markets are now among the most important to monitor, even if you never plan on investing in bonds. The risks reach far beyond Japan, and influence the price of everything.

30 Years of Free Money Is Over

Japan spent three decades with interest rates at or near zero. That era is over. The Bank of Japan's rate is now 1%, the highest in over 30 years, and markets are pricing another hike to 1.25% in a few weeks.

The bond market has moved faster than the BoJ, with 10 year bond yields around 2.9% and 30 year bond yields above 4%. Japan’s debt to GDP is now over 200%. And the cost of servicing the debt could increase to 3.8% in 2028.

Meanwhile the Yen hit a 40-year low against the US Dollar. The problem is that Japan imports most of its food and energy, so a weakening Yen inevitably causes inflationary pressure, leading to further rate hikes. This is a self-compounding loop. Rate hikes are required to combat inflation, but lead to a weaker Yen, causing more inflation.

Why The US Got Involved

In early August the US Treasury joined Japan in a coordinated intervention to buy Yen - the first time America has acted to support the Yen since 1998.

The official line was alliance solidarity, but make no mistake, this was an act of pure self-interest by the US.

Japan is the biggest foreign holder of US government debt, holding over $1.1 trillion in Treasuries. From Japan’s position, the best method of getting dollars is to simply cash in on some of those Treasuries.

Dumping those Treasuries into an already nervous US bond market would push American yields higher at a time the US is trying to push them lower. The US has even opened up a new mechanism for Japan to borrow US dollars against their treasuries without selling them.

The US isn’t bailing out Japan, it’s protecting its own bond market by helping Japan avoid becoming a forced seller. The big problem is that there is no immediate end in sight, this is just kicking the can down the road.

The Underlying Trend

It’s not just Japanese Yields pushing higher, the US 30 year Treasury is around 5.25%, the highest since 2007. The UK, France, Germany and South Korea have all seen yields at the long end of the curve hit multi year highs as well.

The translation is simple. Governments everywhere are issuing more long dated debt than investors are willing to buy at current prices. Investors don’t trust that the returns being offered will represent good value in exchange for locking their money up for 30 years.

Long term rates act as the discount rate for everything. They are the baseline against which everything is measured. They set what future cash flows are worth today, the interest charged on debt a utility company uses to finance a new grid project or the loan a homeowner takes for a renovation.

What This Means For My Japanese Positions

In my recent post about my new Japanese positions I warned that a weak Yen would eat into returns. If the BoJ keeps hiking and the Yen strengthens, that drag reverses in my favour. The trade-off is that a stronger Yen makes Japanese exporters less competitive, so I'd expect some of that gain to be cancelled out.

Hitachi is insulated in the short term, but still exposed long-term. Their order backlog is enormous and already contracted, giving good visibility regardless of rates. But their grid customers are utilities who finance decades long projects with long dated debt. Their strong backlog will dampen any potential blow.

Daikin is more rate sensitive, Heat pumps and HVAC systems are usually bought with finance, often as part of larger renovations which will also be hit by increasing costs. They don’t have the same protective backlog as Hitachi.

The Broader Risk

I wrote in May about the BoJ being trapped by carry trades: Investors who borrowed cheap Yen to buy assets elsewhere. A faster than expected tightening cycle forces the unwind I discussed, and that wouldn't just hit Japanese names, it would hit risk assets across all markets.

This would be further compounded by the rising rates in other bond markets as well. There is a genuine risk that we shift from a risk-on environment for investing, into a more defensive environment where hedging currency risks and rate hikes with more commodities becomes preferable. At some point bonds will become too attractive to pass up, but with such a fragile geopolitical environment I think a broad basket approach might be the most prudent.

Closing Comments

I have made some small adjustments to holdings, and may need to do more if the situation continues to worsen, but my recent move into crop futures should help diversify and de-risk the portfolio substantially from this particular risk.

Bond yield curves are now on my dashboard permanently, and I expect this to remain the case into 2027. Bond markets are boring right up until they're the only thing that matters, and I'd rather understand the risks before it's a headline.

Are you watching bond yields, what do you think? I’d love to read your comments and opinions.

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