Lately there’s been quite a bit of talk about how and whether the new Bank of Japan policy will succeed in pulling the country out of its self-inflicted 2-decade-long economic coma. A couple of days ago the Nikkei experienced its biggest drop since the Earthquake-Tsunami-Nuclear disaster back in 2011, falling by 7% in a single day. After rising over 70% in the 12 months before that. Big deal. Yet that’s not even really the main story here – what seems to be generally regarded as the beginning of the end, clear signs of a Ponzi scheme on top of a Ponzi scheme, is the fact that Japanese 10-year government bond yields had risen to over 1% for the first time since last year, which is supposed to be terrible news for a country with over 230% debt-to-GDP ratio. In other words, we’re all going to die! Or something like that.
First some basics. Long-term yields are an average of expected short-term yields. Given the fact that short-term rates basically cannot go any lower but there is a possibility of them rising tells us that the yield curve must slope upwards (for other reasons as well, but never mind that for now). The next step is to think about what could possibly lead to the market expecting higher interest rates in the future, and how other variables would react in each of the cases – Paul Krugman has proven to be fairly successful in using this method to get through to what’s really happening. Clearly one option would be fears, as the ones linked to above, of a more-or-less imminent collapse of the Japanese economy or its government. A fairly constant level of supply of JGB’s faced with a lower demand for them would of course raise the interest rate they would have to pay. Any such event, or even just widespread expectations of the possibility of such an event, would send pretty much every financial asset tumbling, including the Japanese currency. It didn’t – the Japanese Yen actually rose as the Nikkei fell. Another scenario is that the Bank of Japan has changed market expectations with regards to when it will finally start raising interest rates again – yet why would the market believe that Bank of Japan could start to eventually tighten its monetary policy? Clearly it would only do so if it were successful at hitting its newly set higher inflation target, in which case also the economy would have started moving again. A stronger Japanese economy would also mean a stronger Yen – and indeed, since the beginning of May the Yen has actually risen considerably again. So it seems highly unlikely that the rise in JGB yields has anything to do with fears of financial armageddon and more with expectations of the Japanese central bank doing its job – whereas the recent drop in the Nikkei might also hint at some uncertainty with regards to the strength of that commitment.
Higher inflation is a feature of Abenomics, not a bug. It’s the whole idea behind the policy. Higher yields on Japanese government bonds are a result of that. Yet wouldn’t a country with a debt-to-gdp ratio be crazy to pursuit a policy that would drive up its own borrowing costs? At first sight yes, but the whole point of the exercise is to again start growing the Japanese economy again, and on the other side of the equation we have higher government revenue, lower government outlays as well as a rising denominator that should bring the debt-to-gdp ratio down over time, also reducing the relative amount of interest payments. The only thing where this could go wrong is if growth lagged behind the rise in bond yields. If, for some financial market idiosyncrasies, bond yields rose quickly while the real effects on the economy would lag behind, clearly a considerable financing gap would arise in the short-term. This would, of course, be a real problem that could endanger the entire project. Yet Japanese growth, at least in the first quarter since the new policy has been implemented, seems remarkably strong. All of the indicators that people keep pointing to in order to justify their theories of inevitable doom show nothing of the sort. Quite the opposite: they actually all seem to be moving in precisely the direction one would expect and want them to. There are legitimate grounds on which to argue that the new policy pursued by the Bank of Japan won’t work, or that it’s simply bad policy. But to interpret a predictable and even desired result of the policy as a sign of its failure seems odd to say the least. Higher government bond yields are not a sign that this thing is not working – they are a sign that it is.