Goldman Sachs: The collapse of Japanese bonds has driven a significant drop in U.S. bonds

This week, the most striking aspect of the global bond market is not the surge in U.S. Treasury yields, but the violent fluctuations in the Japanese government bond market. Goldman Sachs' latest research report reveals that the "collapse-like" rise in Japan's long-term government bond yields is actually the behind-the-scenes driver of the sharp decline in U.S. Treasuries.

On the 24th, according to news from the Wind Trading Desk, Goldman Sachs believes that the core reason for the surge in Japanese long-term government bond yields is a severe imbalance in supply and demand. Life insurance companies have sharply reduced their demand due to an expanding duration gap, coupled with increasing concerns over government finances and sell-offs triggered by asset-intensive reinsurance transactions, which together have created selling pressure in the long-term government bond market. These factors have led to a scarcity of buyers in the Japanese government bond market and extremely poor liquidity, even though the Bank of Japan holds a large amount of government bonds.

Goldman Sachs also emphasized that although the current sell-off of Japanese government bonds has not yet transmitted to the Japanese stock or foreign exchange markets, its spillover effects on the global bond market have become increasingly significant. Data shows that since the beginning of this year, 30-year Japanese government bonds have contributed approximately 80 basis points of upward pressure on yields for G4 (U.S., Europe, Japan, and the UK) countries, becoming the largest source of bearish momentum. This means that the surge in U.S. Treasury yields over the past month is likely largely a "byproduct" of the turmoil in the Japanese long-term government bond market.

Looking ahead, volatility in the Japanese government bond market is expected to continue. Although the Japanese government may consider reducing long-term government bond issuance or repurchases, Goldman Sachs believes that without substantial macroeconomic policy responses to high inflation, this volatility will recur. The direction of the Bank of Japan's monetary policy, particularly adjustments to its quantitative tightening path, will be key in influencing market trends in the short term.

Why Have Japanese Long-Term Government Bond Yields Surged?

Goldman Sachs' Japanese interest rate trader Yusuke Ochi pointed out that the recent sharp rise in Japanese long-term government bond yields is mainly due to a significant deterioration in supply and demand balance, which includes changes in life insurance company demand and the tightening of duration gaps, and this trend is not a short-term phenomenon.

• Insufficient demand from life insurance companies: The duration gap for life insurance companies has fallen into negative territory (as of September 2024, it is -1.5 years), making it difficult to sustain demand for long-term government bonds. Particularly for 40-year government bonds, the negative liability discount curve under the new solvency rules has made natural buyers scarce. Additionally, some previous buyers have even turned into net sellers of Japanese government bonds, leading to an extremely pessimistic supply and demand outlook.
• Increasing fiscal concerns: With the Senate elections approaching, almost all opposition parties are calling for a reduction in consumption tax. If the ruling Liberal Democratic Party suffers a significant defeat, concerns over Japan's fiscal outlook will significantly worsen. If this leads to a downgrade in Japan's government bond rating, demand for long-term government bonds may further deteriorate.
• Impact of asset-intensive reinsurance: After October 2023, a series of large asset-intensive reinsurance transactions were announced. In this business model, reinsurance companies take over the assets and liabilities of Japanese life insurance companies and replace them with higher-yielding products to earn interest spreads. In this process, Japanese government bonds are often sold, negatively impacting the supply and demand balance for long-term government bonds

Market Technical Factors and Positioning Bias

Goldman Sachs Japan interest rate strategist Bill Zu pointed out in a report that the current yield level of the 30-year Japanese government bond is now comparable to that of the 30-year German government bond, a situation that rarely persists outside of the effective lower bound period.

This sell-off is relatively concentrated in long-term government bonds, leading to a steepening of the 10-year and 30-year yield spread that exceeds its usual relationship with absolute yield levels. At the same time, Goldman Sachs' measure of the 10-year term premium has not significantly increased, and the movements in the 2-year, 5-year, and 10-year yields are much smaller than the average relationship with the 30-year yield.

The sell-off has been exacerbated by technical and positioning factors, including leveraged flattening positions and extremely poor liquidity in long-term government bond demand. This is largely related to the Bank of Japan holding 52% of the Japanese government bond market.

It is noteworthy that so far, the sell-off of the 30-year government bonds has not been accompanied by broader portfolio pressures on other Japanese assets (such as stocks or currency), which sharply contrasts with the U.S. market. In the U.S., government bond sell-offs are typically accompanied by a weakening stock market and dollar. This decoupling may suggest that the localized weakness of the 30-year Japanese government bonds could be temporary, and if technical and positioning tensions ease, it may even reverse.

Fundamental Causes of Inflation and Supply-Demand Imbalance

Goldman Sachs believes that the fundamental cause driving this round of volatility is the persistent rise in inflation rates, coupled with the aforementioned supply-demand imbalance exacerbated by declining duration demand and the government's ongoing massive financing needs.

• Japanese Inflation Exceeds Expectations: Japan's inflation has consistently outperformed expectations, partly due to soaring rice/food prices that the Bank of Japan cannot control. Forward inflation expectations have risen to cyclical highs, leading to a continuous repricing of equilibrium yields.
• Decreased Demand from ALM Accounts: Similar to other countries, the surge in Japanese yields has led to a decrease in duration demand from ALM accounts, as liabilities shrink due to rising interest rates.
• Lack of Interest from Overseas Investors in Japanese Government Bonds: Monthly trading data from the Japan Securities Dealers Association (JSDA) shows that domestic long-term bond holdings have stabilized, exacerbating concerns about the absorption of long-term bond supply, especially in the context of increased long-duration supply. This is reflected in the recent astonishing weakness of long-term government bond auctions, including the 20-year government bond auction tail reaching the worst level since 1987. This indicates that the assertion that Japanese investors are not purchasing U.S. government bonds but are instead buying large amounts of Japanese duration bonds is incorrect.

Global Spillover Effects: Japanese Bonds Dragging Down U.S. Bonds

Goldman Sachs points out that the spillover risk of rising Japanese interest rates on the global bond market is a question frequently raised by clients. Current evidence is mixed.

On one hand, Goldman Sachs believes that technical factors are the main reason for the volatility of Japanese long-term government bonds, which may imply limited impact on other markets. Additionally, the common factors of G4 yields (the first principal component) explain relatively little of the total variance of the long-term curve (such as the 10-year to 20-year), indicating that changes in long-term yields are more idiosyncratic On the other hand, there is more evidence that Japan's long-term government bonds are beginning to exert greater pressure on global long-term yields. Goldman Sachs' variance decomposition model shows that since the beginning of this year, 30-year Japanese government bonds have contributed approximately 80 basis points of upward pressure to G4 yields, making it the largest source of bearish forces within G4. Almost all of this occurred after April 2, which may reflect a poor liquidity backdrop, cautious risk-taking, and heightened fiscal concerns (which are also evident in other G4 markets).

This means that the recent selling pressure on U.S. Treasuries is actually not primarily driven by domestic factors, but rather a byproduct of Japan clearing its backend positions.

Investors Face Ongoing Volatility Risks

In the face of ongoing turmoil in the bond market, the Japanese Ministry of Finance may consider reducing the issuance of 30-year and 40-year government bonds, or even repurchasing non-current bonds. However, historical experience shows that proactive fiscal tightening has never truly occurred without a market crisis forcing it, as it would be tantamount to political suicide for the ruling party.

A more likely catalyst is the Bank of Japan's monetary policy decisions, including any adjustments to the path of quantitative tightening.

Goldman Sachs economists maintain their view that the next interest rate hike will occur in January 2026, with a terminal rate potentially reaching 1.5% in the distant future. Before that, Goldman continues to predict upward pressure on 5-year and 10-year rates, with the performance of these two curve points expected to be weaker than that of 30-year Japanese government bonds over the next 12 months.

Goldman analysts admit that it remains unclear how the current volatility in Japanese government bonds will be resolved. However, given the macro drivers facing major bond markets—high inflation and large bond supply—this repricing process has already been quite severe, and the longer it lasts, the more destructive it will be for both domestic and international markets.

As Goldman’s Zu summarized:

"The wildfire in 30-year Japanese government bonds may be fueled by local weather conditions, but the adverse climate facing duration assets suggests that global curves will continue to experience volatility."