TOKYO — As Kazuo Ueda mulls whether to hike interest rates this week, a powerful constituency is staring back at the Bank of Japan governor: the “bond vigilantes.”
Very few think Ueda’s BOJ will hike rates on Friday, despite Japanese policymakers going out of their way to claim the rate “normalization” process remains on track.
The reason has less to do with tepid growth or lackluster consumer spending. Rather, it’s Tokyo’s titanically large public debt and the fact that investors are increasingly concerned about it.
“Japan is much closer to a debt crisis than people think,” argues economist Robin Brooks at the Brookings Institution.
Estimates of the true magnitude of Japan’s debt-to-gross domestic product ratio range from 240% to 260%. Either or anywhere in between means Japan has the biggest debt burden by a wide margin in the developed world.
This problem isn’t new, of course, but it’s suddenly coming to a head. The most obvious reason is the difficulty Tokyo is having attracting bids at auctions of Japanese government bonds (JGBs) this year.
Significantly, 20-year bond yields have recently risen to the highest levels since 1999. That was the year Japan became the first Group of Seven economy to slash rates to zero.
So why, if Japan managed to muddle along without crisis for over a decade, is its debt now a problem?
“There are two reasons,” Brooks explains. “First, debt levels have risen sharply all across the world since Covid, which is making markets much less accepting of out-of-control fiscal policy.”
After all, he observes, the UK and France have debt levels substantially below Japan, but are struggling with early-stage debt crises. “Second,” he notes, “prior to Covid it seemed like inflation would always be low, which meant lower and flatter yield curves. That’s also gone out the window.”
Japanese inflation is running at a 3.1% year-on-year rate, well above the BOJ’s 2% target. Fears that US President Donald Trump’s tariffs are increasing inflation pressures — and the chaos surrounding his trade policies — aren’t helping. The resulting spikes in US yields are reverberating around the globe, hitting bond and stock markets.
“We think risk premia will be politically driven and expect them to move higher if concerns about expansionary fiscal policy intensify and decline if those concerns ease,” says Takahiro Otsuka, a strategist at Mitsubishi UFJ Morgan Stanley Securities.
SMBC Nikko Securities strategist Ataru Okumura adds that “given that foreign investors had been by far the dominant source of demand for super-long JGBs in the first half of 2025, the sharp pullback in net buying raises concerns about potential instability in the long end of the yield curve going forward.”
Granted, fears of financial Armageddon in Tokyo have been making the rounds for over a decade and a half. Bets on a JGB crash are one of the most obvious “widow maker” trades anywhere.
A dozen years ago, shorting JGBs didn’t work out well for Kyle Bass of Hayman Capital. Or David Einhorn of Greenlight Capital before that. Officials at Japan’s Ministry of Finance tend to be quite good amidst a crisis.
Trump’s tariffs, though, have injected extreme uncertainty into global debt markets. And, in Japan’s case, an unforced error by outgoing Prime Minister Shigeru Ishiba, who in May said Tokyo’s deteriorating finances are “worse than Greece.” The comment made global headlines for all the wrong reasons.
Ishiba was trying to make a more nuanced point, aimed at dissuading lawmakers from cutting taxes to juice GDP. He worries that the step might draw the attention of credit rating companies to Tokyo’s precarious finances.
Japan’s demographic trajectory hardly helps. Japan’s aging, shrinking population features one of the globe’s lowest birthrates. In 2024, the population of Japan shrank by 0.75%, the largest drop since records began in 1968.
Around the time Ishiba was comparing Japan to Greece, a routine May 20 sale of $6.9 billion of bonds maturing in 2045 attracted the weakest demand since 2012.
The “tail,” the spread between the average and lowest-accepted price, was the ugliest since 1987. Since then, a series of 20-year, 30-year and 40-year JGBs have been alarmingly undersubscribed.
Part of the problem is how Trump’s tariffs are wreaking havoc with US Treasuries and the dollar. That turmoil was one of the key reasons why the BOJ shelved its two-year process of raising rates from zero, at least temporarily.
Now, political uncertainty in Tokyo is raising the stakes. In late July elections, Ishiba’s Liberal Democratic Party performed dismally, prompting him to resign earlier this month.
Now, the LDP controls neither house of parliament, forcing the party to partner with pro-tax-cut opposition parties. The specter of fiscal loosening has the bond vigilantes ready to pounce.
A pivot back to aggressive profligacy could make the volatility in Japanese markets seen in May look tame by comparison. That could vastly raise debt borrowing costs for Japan’s $4.2 trillion economy.
Analyst Thomas Rookmaaker at Fitch Ratings notes that “higher rates and the Bank of Japan’s quantitative tightening will put upward pressure on government borrowing costs.” This helps explain why the BOJ is throttling back on tightening operations.
In July, the BOJ announced plans to slow the pace at which it trims monthly bond purchases to quarterly reductions of 200 billion yen (US$1.36 billion) from 400 billion yen ($2.7 billion). Not everyone agrees this was a wise move.
As Commerzbank economist Michael Pfister points out, “the inflation rate has remained above the 2% target for over three years now, and survey-based inflation expectations have risen significantly again recently.”
Yet many observers point to what’s going on with Japan’s yield curve. Specifically, how much the 10-year-to-20-year part of the maturity spectrum has risen as the BOJ has tried — with little success — to continue reducing its massive JGB holdings without unnerving the market.
“It’s tempting to think that the BOJ can just sit on its holdings if its balance sheet run-off is causing yields to spike,” says Brooks. “But things aren’t that simple. The yen has depreciated 25% against the dollar in recent years, as global interest rates have risen. The Bank of Japan is under pressure to catch up to this rise in global yields, for fear that the yen could go into another depreciation spiral.”
Yet the bottom line, Brooks says, is that exceptionally high government debt is putting Japan in a terrible bind. If Japan sticks with low interest rates, it risks further yen depreciation, which could cause inflation to run out of control.
If it anchors the yen by allowing yields to rise further, this could put Japan’s debt sustainability at risk. “This Catch-22,” he says, “means a debt crisis is much closer than people think.”
Of course, Brooks concludes, “a debt crisis isn’t inevitable. It’s possible that the US goes into recession, which will cause US and global yields to fall. That will buy Japan time. But in the end, the only sustainable way out of this Catch-22 is for Japan to cut spending and/or raise taxes.”
Here, the US Federal Reserve’s rate decision on Wednesday is important. Fed watchers generally agree that Chair Jerome Powell’s board will lower rates by 25 basis points. Yet any hints of bigger reductions on the way could backfire, sending US yields sharply higher.
Oddly, says strategist David Kelly at JPMorgan Asset Management, a Fed rate cut could intensify risks facing global bonds and stocks, given Trump’s demands for lower rates.
“To the extent that the Fed’s decision this week is seen as a capitulation to political pressure, a new layer of risk is being added to US financial markets and the dollar,” Kelly says. There’s little evidence in the Fed’s own forecasts for growth and inflation to justify rate cuts, he adds.
“By the fourth quarter of this year, inflation could be 1.2 percentage points above the Fed’s target and rising, while unemployment would be just 0.3 percentage points above their target and stable. If this is the outlook, why should the Fed cut at all?”
Trump’s campaign to fire Powell — and remove Fed Governor Lisa Cook — is undermining trust in the dollar. As investors and central banks cash out their dollar assets, the fallout on global markets could be extreme. The US Senate, meanwhile, rushed Trump loyalist Stephen Miran onto the Fed Board in time for the September 16-17 policy meeting.
That very likely puts a third dissenting vote in favor of bigger rate cuts on the Federal Open Market Committee. It also likely increases the odds that global markets will view any Fed rate cuts as suspect.
It’s anyone’s guess, meanwhile, who will be leading Japan six weeks from now. “The trouble,” notes Nicolas Smith, a strategist at CLSA Japan, “is that this time the party that had run Japan, almost without break, since 1955 could quite possibly split.”
The main frontrunners to replace Ishiba are LDP party mates Shinjiro Koizumi and Sanae Takaichi. At 44, Agriculture Minister Koizumi, the scion of a political dynasty, represents generational change. Former Economic Security Minister Takaichi, 64, would be the nation’s first female leader.
As lawmakers debate tax cuts, any momentum toward reducing Tokyo’s runaway debt, slight as it may be, will likely be all but lost. That could send JGB yields sharply higher, and make future BOJ rate hikes a non-starter.
Japan Inc realizes that it’s time to extricate Asia’s No 2 economy from 26 years of zero rates. Two-plus decades of free money deadened Japan’s animal spirits. Corporate CEOs have been disincentivized to innovate, restructure and take risks.
The trouble for Japan is that essentially everyone is exposed. If JGB yields surge, banks, companies, local governments, pension and insurance funds, universities, endowments, the giant postal system and retirees get hurt. As JGB yields continue to rise, Tokyo will face increasing difficulty in servicing the developed world’s largest debt burden.
On the one hand, this is in many ways a Trump/dollar story.
“People can talk about Japanese politics, but the real driver of dollar/yen is not Japanese politics, or Japanese interest rates,” says Marc Chandler, strategist at Bannockburn Forex. “It’s US interest rates, and with the market pricing in about a 10% chance of a 50 basis point cut, the dollar is falling.”
On the other hand, though, it’s also a yen story. The worry in Tokyo is that a continued drop would trigger intense yen volatility and the unwinding of the so-called “yen-carry trade.”
Twenty-five years of holding rates at, or near, zero turned Japan into the globe’s top creditor nation. For decades, investment funds borrowed cheaply in yen to bet on higher-yielding assets around the globe.
As such, sudden yen moves slam markets virtually everywhere. Now, between erratic US policy and the specter of a fresh borrowing binge in Tokyo, a Japanese debt crisis is perhaps a lot closer than many realize.
Follow William Pesek on X at @WilliamPesek