Japan's Debt Faces 25-Year High Sell-Off Amid "Internal and External Troubles

As global bond markets suffered a heavy blow and the Bank of Japan's policy shift approaches, Japanese government bonds have recorded their largest quarterly decline since 1998. With the Bank of Japan easing its grip on the market, Japanese government bonds have experienced the most severe quarterly sell-off in over two decades. This serves as a reminder to investors that the performance of Japanese government bonds is to some extent dependent on the support of public sector institutions like the Bank of Japan to outperform their global peers.

According to data compiled by foreign media as of Thursday, Japanese government bonds fell by 3% in the third quarter, marking the largest drop since 1998. Meanwhile, due to lingering inflationary pressures that have sparked expectations of higher interest rates for an extended period, global government bonds outside of Japan fell by 4.6% during the same period, the largest decline in a year.

Although the leaders of the Bank of Japan have stated the need to continue implementing stimulus measures to support the still unstable economic recovery, there is growing speculation that the Bank of Japan will end its negative interest rate policy early next year. Bets on the Bank of Japan's shift towards tightening policy and the collapse of global bonds have led to the Japanese benchmark 10-year government bond yield rising to a decade high this week.

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On Friday, Japanese government bonds plummeted across the board. Subsequently, the Bank of Japan announced an unplanned bond purchase operation, intending to purchase 300 billion yen worth of 5-10 year bonds. Despite the news, the Japanese 10-year government bond yield remained stable at around 0.765%.

Singapore-based analyst Mark Cranfield commented that the Bank of Japan intended to buy Japanese government bonds on the day when yields rose across the board, but the scale was too small to make a so-called significant statement, nor did it cause any drastic market fluctuations. Traders are now well aware that the Bank of Japan is in a dilemma, as it wishes to avoid exacerbating the pain of a weak yen.

In addition to concerns about the Bank of Japan exiting ultra-loose monetary policy leading to a bond crash, traders believe that the Ministry of Finance could also be a catalyst for a repeat of the 1998 bond market collapse.

At that time, the Ministry of Finance stated that the department would stop directly purchasing long-term government bonds on behalf of postal savings and public pension funds, as it needed to retain cash to pay for tax cuts and stimulus measures. However, the timing of this decision was not good, as it planned to sell a record number of bonds in the next fiscal year. The expectation of a large influx of new bonds into the market led to the Japanese 10-year government bond yield surging 180 basis points from its low in September 1998 within five months. In the last quarter of 1998, Japanese government bonds plummeted by 6.2%.

Keisuke Tsuruta, a senior fixed income strategist at Tokyo-Mitsubishi UFJ Morgan Stanley Securities, said, "The significant deterioration in the performance of Japanese government bonds this quarter once again demonstrates the huge impact of the public sector on the market. However, speculation about the end of negative interest rates next year may intensify, so the Bank of Japan will continue to dominate the bond market."

Bank of Japan Governor Haruhiko Kuroda reiterated his stance on maintaining easy policy last week. However, as the yen approaches the psychological threshold of 150 against the US dollar and exerts upward pressure on import prices, actual tightening may arrive ahead of schedule.Morgan Stanley Mitsubishi UFJ Securities forecasts that the Bank of Japan (BOJ) will end its negative interest rate policy and Yield Curve Control (YCC) program in January next year. The bank's economists Takeshi Yamaguchi and Masayuki Inui wrote in a report on Wednesday, "Based on exchange rate trends as well as wage and price trends, we believe there is a possibility that the BOJ's monetary policy stance could be corrected ahead of schedule in December 2023."

On the other hand, the uncertainty surrounding price trends keeps the BOJ cautious. Inflation in Tokyo slowed more than expected in September, supporting the BOJ's viewpoint. Tokyo's consumer prices (CPI) excluding fresh food rose by 2.5%, down from 2.8% in August, mainly due to the decline in electricity and gas costs. Economists had previously forecasted a 2.6% increase. The core indicator, which excludes fresh food and energy prices, has dropped to 3.8%, marking the first slowdown in three months, indicating that core inflation may have peaked.

The BOJ will continue to closely monitor price trends. As inflation remains stronger than initially expected, the BOJ may need to revise its price forecasts upwards at the October meeting.