Borrowing short to repay long, the Bank of England and Bank of Japan are leading the abandonment of long-term bonds, shifting towards high-frequency "interest rate gambling."

Borrowing short to repay long, the Bank of England and Bank of Japan are leading the abandonment of long-term bonds, shifting towards high-frequency "interest rate gambling."

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Governments of major economies around the world are quietly adjusting their debt strategies, increasingly moving away from traditional long-term bonds and instead embracing shorter-term debt.

Leading this trend are the UK and Japan. According to reports, the UK this year has cut the issuance of its long-term government bonds to a historic low and is considering expanding its ultra-short-term bills market. Meanwhile, after a sell-off in long-term bonds, the Japanese government is also responding to market calls by planning to increase the issuance of short-term debt.

The shift in strategy is driven by central banks gradually phasing out their years-long bond-buying programs, leading to reduced demand for long-term bonds and rising government borrowing costs. Faced with already high debt levels, policymakers are choosing to issue lower-yield but more frequently rolled-over short-term bills in hopes of easing fiscal pressure. However, this is tantamount to betting that interest rates will fall in the future.

This is not an isolated move. The US is relying more on short-term Treasury bills to finance its federal deficit, and countries like Australia have proposed similar policies. Bloomberg's aggregate bond index shows the average duration of global government bonds has dropped to its lowest level since 2014. Even so, the UK and Japan are undoubtedly the most radical in both the decline of long bond demand and their policy adjustments.

Shift in Demand, Traditional Buyers Withdraw

The core driving force behind this global shift lies in the structural changes in demand from traditional buyers of long-term bonds. Central banks worldwide are shrinking their balance sheets, increasing governments' financing costs.

In the UK, fixed income pension plans, which for decades have been stable buyers of long-term bonds, are now mostly winding down, creating a significant gap in market demand. Japan faces a similar situation. Takahiro Otsuka, Senior Fixed Income Strategist at Mitsubishi UFJ Morgan Stanley Securities, noted that banks and life insurance companies' demand for ultra-long-term bonds is not what it used to be. Additionally, investors are concerned about Sanae Takaichi's plan to finance an economic stimulus package through an additional budget, fearing it could lead to further supply pressure on bonds.

Market dynamics themselves have also made short-term borrowing more attractive. Currently, the yield gap between long- and short-term bonds is widening significantly. This year, the yield on UK 30-year bonds hit its highest level since 1998, and the premium over 2-year bonds rose to its highest since 2017. In Japan, this spread has also widened to its highest since at least 2006.

The huge spread makes issuing short-term debt very attractive in terms of cost. Data shows that this fiscal year, UK government bonds with durations less than 7 years are expected to account for 44% of new issuance, a rise of nearly 20 percentage points compared to fiscal year 2015-16. In Japan, bonds with durations of 5 years or less are expected to make up about 60% of new issuance this fiscal year, up from 56% in fiscal year 2015.

"Interest Rate Gamble" and Fiscal Sustainability Risks

However, aggressively shortening debt duration is essentially governments betting that long-term bond yields are too high and will fall in the future. The risk in this strategy is that if interest rates fail to fall or even rise, governments will face uncontrollable costs when they frequently roll over debt.

"The risk is that if rates rise, your interest bill will suddenly surge," said Evelyne Gomez-Liechti, strategist at Mizuho International in London.

Hiroshi Namioka, Chief Strategist at T&D Asset Management, also warned:

"If the duration is only two years, it means refinancing must be very frequent. Continued rolling over of short-term loans will raise questions about fiscal sustainability, and caution is needed regarding how this will make future fiscal outlooks harder to predict."

Although the US is also increasing issuance of short-term Treasury bills, its market situation is markedly different from other countries. As of the end of October, short-term Treasury bills accounted for about 22% of the total outstanding US federal debt, and according to Citigroup forecasts, this could climb to 26% by the end of 2027.

Unlike the UK and Japan, the US has huge and sustained demand for such short-term assets. More than $8 trillion is parked in money market funds, giving the Treasury flexibility to adjust according to market demand. US Treasury Secretary Scott Bessent said last month that his department is "closely monitoring potential long-term changes in demand for specific types of US debt" and will respond accordingly.

Gennadiy Goldberg, head of US rates strategy at TD Securities, believes this allows "the Treasury to rely more on bill issuance, thereby relieving pressure on long-end yields, since they can delay plans to increase the size of coupon auctions until the end of 2026."

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