Yields on Japan's longest government bonds soared to unprecedented levels on Tuesday, sparking concerns across financial markets and highlighting the nation's deteriorating fiscal situation. The sharp increase followed a weak debt auction that exposed significant cracks in investor confidence.

According to the Financial Times, the yield on 30-year bonds surged to 3.14%, while 40-year yields climbed to 3.61%. Both saw a 0.17 percentage point increase in a single session. The 20-year bond also experienced a significant jump, rising 15 basis points to 2.56%. The auction's "tail"—the gap between the highest and lowest accepted prices—was the widest it has been since the 1980s.

Bank of Japan's Tapering Policy Under Scrutiny

The Bank of Japan (BoJ) has spent the past year gradually reducing its presence in the bond market as it attempts to move away from its long-standing ultra-loose monetary policy. This strategy is now facing intense criticism, with traders directly attributing Tuesday's market turmoil to this tapering, which has caused volatility across the entire yield curve.

Mike Riddell, a fund manager at Fidelity Investments, warned that the surge in yields could lead to "contagion and further weakness in the long end of global bond markets" if Japanese investors begin repatriating their overseas assets. Given Japan's substantial holdings of foreign assets, any significant capital repatriation could severely impact other global markets. The Ministry of Finance is now actively involved in addressing the crisis.

Minutes after Tuesday's auction, the BoJ released feedback from market participants regarding the tapering process. Several banks and brokers advised the central bank to reconsider its approach, particularly concerning long-dated bonds.

Société Générale estimates that the private sector will need to absorb an additional ¥60 trillion in new debt before the fiscal year concludes in March 2026. This substantial burden raises questions about who will purchase this debt, especially as life insurance firms, traditionally major players in the long-end market, are reportedly shifting their strategies and reducing their exposure. This creates a significant gap in domestic demand that the market has yet to resolve.

Political Instability Adds to Woes

Compounding the financial stress is a deepening political crisis within the Japanese government. Prime Minister Shigeru Ishiba is facing increasing skepticism from within his own coalition, with low approval ratings and a perceived weak political base.

Ishiba has also failed to secure an agreement with US President Donald Trump on tariffs, leaving Japan's trade position vulnerable. With upper house elections scheduled for July, there are growing expectations that Ishiba might resort to promising tax cuts to bolster his support. Analysts warn that such a move could further destabilize Japan's budget, which is already grappling with a public debt load exceeding 200% of GDP.

Global Ramifications of Japan's Bond Chaos

While the current bond market instability may seem isolated to Japan, its effects are not. The last time the yen carry trade came under pressure, on August 8, 2024, global equity markets experienced a decline. The yen carry trade involves borrowing yen at low interest rates to invest in higher-yielding currencies like the US dollar. As Japanese yields climb, this trade becomes riskier, forcing large investors to pull capital from riskier assets worldwide.

Currently, the risk of a repeat crash is not high, but it is not negligible either. US interest rates remain higher than those in Japan, keeping the carry trade attractive for now, though this gap is narrowing.

Current market pricing indicates a 94.7% probability that the Federal Reserve will maintain rates between 425–450 basis points next month. This probability drops to 71.2% for the July 30 meeting. By September, there's a 53.1% chance that rates will fall to 400–425 basis points.

If US rates decline while Japanese yields remain elevated or continue to climb, the carry trade could once again unravel. Such a scenario would see capital flow back into Tokyo, draining liquidity from global markets and potentially impacting everything from US stocks to emerging-market debt. Following Tuesday's events, no one is dismissing this possibili

ty any longer.

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