Wall Street "closely watches": If Japan doesn't want interest rates to spiral out of control, it can save Japanese bonds this way, but the cost is U.S. bonds!

Japan's long-term government bond market is experiencing a fierce sell-off, and Wall Street is closely watching a potential bailout plan: the Japanese government may ask state-owned institutions to buy large amounts of domestic government bonds, with the funding possibly coming from selling their holdings of U.S. Treasury bonds.

This week, the auction of 20-year Japanese government bonds faced a lackluster response, with yields soaring and severely impacting long-term bonds. The yield on 40-year government bonds approached 3.7%, having risen a full percentage point since April. For bonds with a duration close to 20 years, investors have lost nearly 20% in just a few weeks.

Ajay Rajadhyaksha, Chairman of Global Research at Barclays, stated in a media interview, "If this wave of selling continues, the Japanese government may have to mobilize state-owned entities to support the government bond market."

Rajadhyaksha proposed a much-discussed possible path: key institutions like Japan Post and the Government Pension Investment Fund (GPIF) may be "quietly notified" to increase their purchases of government bonds. He said, "If there is a real need, the quickest way would be to tell Japan Post: 'You need to immediately buy $50 billion of long-term government bonds.'"

However, this plan is not without cost: to raise funds for purchasing Japanese bonds, these institutions are likely to sell overseas assets, with U.S. Treasury bonds being the first to go—these are the most held foreign bonds by Japanese investors.

The "Behind-the-Scenes Driver" of Japan's Bond Market Collapse

In a commentary for the Financial Times, Rajadhyaksha bluntly stated that the Japanese bond market is "in trouble," pointing out several key factors leading to the collapse of the Japanese bond market:

• Inflation remains above 2%: Japan's inflation rate is currently at 3.6%, having been above 2% for the past three years, which means that the 3.15% yield on 30-year bonds is effectively a negative real rate.

• Traditional buyers are exiting: Japanese insurance companies have almost stopped purchasing ultra-long bonds to meet recently introduced economic solvency ratio requirements.

• Fiscal concerns are escalating: The U.S. is urging Japan to increase defense spending to 3% of GDP (currently at 1.6%). The ruling coalition is considering additional budgets, while the opposition is pushing for a reduction in the consumption tax.

• The Bank of Japan begins quantitative tightening: The central bank still holds an astonishing 50% or more of Japanese government bonds. However, with the end of the deflation era, the central bank has begun to reduce its balance sheet, allowing existing bond holdings to gradually be released into the market.

The turmoil in Japan's bond market has already begun to affect global markets. Since Tuesday, the yield on U.S. 30-year Treasury bonds has risen nearly 20 basis points, reaching its highest level since the 2008 crisis, exceeding 5%.

"Duration is interchangeable among developed economies. If investors see yields on Japanese government bonds or UK government bonds rising sharply, they will rush to sell duration exposure in similar bond markets. What happens in Japan will not be limited to Japan," Rajadhyaksha warned.

What "Bailout Plans" Does Japan Have?

In his Financial Times article, Rajadhyaksha analyzed several possible solutions, including that the Bank of Japan could raise interest rates more quickly. However, the central bank's attitude at the last meeting was unexpectedly more dovish, and the next meeting will not be until mid-June.

Rajadhyaksha believes that Japanese policymakers generally do not tend to take action between meetings, and unless economic data significantly weakens in the coming weeks, the rise in yields may continue.

At a time when the market urgently needs guidance, Bank of Japan Governor Kazuo Ueda remains silent on the surge in government bond yields. It was reported that Ueda stated after attending the G7 finance ministers and central bank governors meeting in Banff, Canada, on Thursday: "I do not want to comment on the specific details of the short-term trends in bond yields, but I will certainly continue to monitor closely."

One alternative is for the Ministry of Finance to reduce the issuance of long-term bonds and increase the issuance of short-term bonds to alleviate pressure on long-term rates. However, the Ministry of Finance already did this in April without success and is also unwilling to take unplanned actions.

Therefore, having the Japanese government "guide" state-owned institutions to buy bonds may be the most direct and effective way.

Rajadhyaksha acknowledges that it would be politically difficult for the Japanese Ministry of Finance to influence the investment decisions of quasi-government institutions in this way. However, given that the Bank of Japan is unlikely to change its policy between its scheduled decision dates, this is a feasible option for officials hoping to control market trends.

However, even if institutions like Japan Post do intervene to purchase, Rajadhyaksha admits that this is only a temporary solution. He stated: "If you want to find fundamental reasons for why the 30-year bond should remain at current levels rather than being 50 basis points higher based on the current inflation situation or Japan's fiscal condition, I cannot do that."