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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for 06/02/2025. I'm Phil Adler. The recent sharp sell off in Japanese bonds has worrisome implications for investors across the globe. Confluence associate market analyst Thomas Wash joins us today to discuss where this might be heading. Thomas, the sell off in Japanese bonds appeared to be sudden.
Phil Adler:What prompted it?
Thomas Wash:Well, basically, the whole thing started with a rough auction for Japan's Twenty Year bonds. Investors just weren't biting, which set off alarms. This came a day after Japan's Prime Minister made some offhand comments comparing the country's debt to Greece's mess back in the day, and that really spooked the market. On top of that, Moody's had just downgraded US debt, so everyone was already jumpy about government borrowing. Put it all together and boom.
Thomas Wash:Suddenly, nobody wants to hold Japanese bonds.
Phil Adler:Well, I've heard stories about skyrocketing prices in Japan. There's been an outcry, for instance, about the rising price of rice, which has nearly doubled. What exactly are the challenges for Japan's economy right now?
Thomas Wash:Yeah. I think that the rice price hikes are just a piece of the puzzle. Japan's in this weird spot where after years of very little or no inflation, prices are finally rising. But now they're rising too fast for comfort. The Bank of Japan is stuck between a rock and a hard place.
Thomas Wash:If they raise rates to cool things down, the government debt payments, already insane, will shoot up even more. But if they do nothing, regular folks keeps getting squeezed at the grocery store. It's like they finally got what they wish for, inflation, and now their economic policy has gotten that much more complicated.
Phil Adler:Thomas, charts in your report show the Bank of Japan is by far the dominant holder of Japanese bonds. How did this happen?
Thomas Wash:Yeah. It's wild. The Bank of Japan basically is the Japanese bond market at this point. See, they spent years buying up bonds like crazy to keep rates super low and kick start the economy. Then they doubled down with this policy called yield curve control where they promised to cap rates no matter what.
Thomas Wash:Problem is when traders tried to push yields higher, the Bank of Japan had to swoop in and buy even more bonds to keep them in check. Before they knew it, they owned half the market. It's like if your mom kept buying your lemonade just to keep you in business. Eventually, she's just the only customer you have.
Phil Adler:Well, the Bank of Japan has been trying to reduce some of the government debt it holds, but with so much debt issuance on the market, rates have nowhere to go but up, it seems, to try to attract investors. Do you think the Bank of Japan might reverse course on its quantitative tightening program?
Thomas Wash:You know, I think the Bank of Japan is in a precarious position. While it has begun tapering its bond purchases, allowing some holdings to mature without reinvestment, the recent surge in yields has intensified pressures for the central bank to intervene. Market participants fear that without BOJ support, rising yields could destabilize Japan's debt market. However, as of late May, the central bank appears to be adopting a cautious stance, likely awaiting the outcome of an upcoming forty year bond auction. If demand for that falters, the BOJ may be forced to step back in either by halting its tapering efforts or even resuming bond purchases to stabilize yields.
Phil Adler:Thomas, let's turn to how this might impact US markets. Japan not only holds a lot of its own debt, it also holds a lot of US debt. Do you think Japanese holders of US debt might abandon treasuries in favor of Japanese bonds?
Thomas Wash:You know, and and that's a great question. And, you know, yeah, it's something a lot of folks are sweating over. Japan's sitting on over a trillion dollars of US debt, and if their own bonds start looking juicier, pension funds and insurers might start bringing money home. That said, US treasuries still pay way better, and let's face it, they're the ultimate safe haven. So it's not like Japan's gonna dump them overnight, but even a small shift can rattle markets.
Phil Adler:What about the potential impact on the currency markets?
Thomas Wash:You know, I think currency markets are a key piece of this puzzle. The yen has strengthened significantly this year partly due to its safe haven status, expectation of tighter monetary policy, and speculation that the White House may discourage Japan from intervening to weaken its currency. A stronger yen makes repatriation more appealing for Japanese investors as converting dollar denominated assets back into yen becomes more profitable. This dynamic could accelerate capital flows out of US assets, further tightening financial conditions in America while boosting Japan's bond market.
Phil Adler:Thomas, is this sell off in Japanese bonds in any way a warning for US markets?
Thomas Wash:In some ways, yes. While The US benefits from deeper markets and higher yields, Japan's situation highlights the risks of excessive debt accumulation and central bank dominance in bar markets. If Japanese investors reduce their treasury holdings, it could push US yields higher, increasing borrowing costs for the governments and corporations. Additionally, a stronger yen could unwind carry trades where investors borrow in low yielding currencies like the yen to invest in higher yielding assets, potentially triggering volatility across global markets.
Phil Adler:I imagine this isn't good news for the Japanese stock market either.
Thomas Wash:You know, I think we all know that higher yields typically weigh on equities by raising corporate borrowing costs and reducing the present value of future earnings. Japan's stock market also faces headwinds from trade tensions, particularly with The US. However, there is a potential upside for the future. If US Japan trade negotiations progress favorably, possibly during this upcoming g seven summit, tariff reductions could provide some relief. For now though, equity investors should brace for more volatility.
Phil Adler:Thomas, how do you expect all this to play out?
Thomas Wash:Well, the near term will likely see continued volatility in Japanese government bonds as the BOJ navigates its exit from ultra loose policy. A key variable is US Japan relations. Reports suggest that Japan has even proposed a joint sovereign wealth fund, which if realized could ease fiscal pressures for both nations. Longer term, Japan must address its debt sustainability either through growth reforms or fiscal tightening. For markets, the path forward hinges on whether the BOJ can engineer a smooth normalization without triggering a crisis.
Phil Adler:Thomas, do you think investors should be avoiding government debt across the board right now?
Thomas Wash:You know, not necessarily. Bonds can still be a lifesaver if the economy tanks, especially US treasuries. If growth slows, demand for safe haven assets could drive prices higher. That said, diversification is crucial. Investors might consider shorter duration bonds to mitigate interest rate risk.
Thomas Wash:The key is to avoid overexposure to any single market given the current uncertainty.
Phil Adler:Bottom line, what are alternatives for investors?
Thomas Wash:In this environment, selectively positioned equities such as large firms with robust earnings, low debt, and resilient supply chains could perform well. Gold offers a traditional hedge against volatility. Ultimately, a balanced approach, blending defensive assets with selective growth exposures may be the most resilient strategy.
Phil Adler:Thank you, Thomas. The title of this week's report is The Japan Problem, and you can find a link to the written report, which includes some helpful charts, on the Confluence webpage, ConfluenceInvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.