The Japanese version of the "Truss shock" may unfold, as the supply-demand imbalance of ultra-long-term bonds has yet to be fully priced in.

With the imminent announcement of a 42.8 trillion yen stimulus package, the Japanese market is undergoing a severe test. Nomura Securities warns that the Japanese market faces fiscal risks similar to the UK’s “Truss shock” in 2022, and the deteriorating supply-demand for ultra-long-term government bonds is not yet fully priced in by the market.

According to a Wallstreetcn article, the Japanese government is in the final stage of drafting a large-scale economic stimulus package, with government spending estimated at around 21.3 trillion yen. Including private sector investment, the total package will reach as high as 42.8 trillion yen. This figure far surpasses the previous administration’s 13.9 trillion yen plan, triggering deep concerns in the market about fiscal discipline. There has been heavy selling in the Japanese government bond market, with 30-year bond yields hitting historic highs, and 10-year and 5-year bond yields both reaching their highest levels since 2008.

(Japan’s 10-year bond yield has accelerated upward this week)

On November 20, according to Trading Desk, Nomura Securities’ latest report states that as long as concerns about a Japanese “Truss shock” persist, foreign investors will continue to avoid the Japanese market. The comprehensive weakening of the yen along with weakness in ultra-long-term bonds is a clear signal for investors to sell Japanese bonds. The USD/JPY exchange rate has returned to the 157 level after 10 months, approaching a dangerously sensitive area that may trigger official intervention at any time.

The report also points out that if ultra-long-term bond supply-demand further deteriorates, there is still considerable room for the yield curve to steepen. The curve steepening driven by fiscal anxiety has not yet fully reflected the extent of ultra-long-term supply-demand deterioration in April-May. Currently, the 30-year government bond’s supply-demand premium index is 48 basis points, below the April-May peak of 67 basis points, but still with potential to widen significantly. Term premium refers to the additional yield investors gain by holding long-term government bonds.

The “Truss shock” refers to the autumn of 2022, when Liz Truss, newly appointed UK Prime Minister, launched a series of new policies including large-scale deficit-financed tax cuts, causing a market collapse, a dramatic plunge in the pound, a surge in UK government bond yields, and pushing UK pension funds to the brink of collapse. She was forced to reverse most of these measures, fired the Chancellor of the Exchequer, and herself resigned just 44 days into office.

Analysis notes that Sanae Takaichi’s economic agenda is undergoing a severe reality check; details of the stimulus plan to be announced on Friday will determine how far the “Sell Japan” trade might go. Just as RBC BlueBay Asset Management’s CIO Mark Dowding said: “If Sanae Takaichi loses policy credibility, investors will begin to sell all assets.”

Fiscal Discipline Concerns Dominate Market Sentiment

The report states that the market’s focus is on whether the reflationary faction within the LDP can gain momentum, intensifying fiscal policy concerns, and whether Finance Minister Katsuyuki Katayama can curb this trend.

At a press conference, Katayama raised the urgency of yen depreciation to a level of “deep concern,” and stated that the quality and size of the stimulus measures will not seriously damage confidence in the yen or the credibility of Japanese government bonds.

Nomura especially emphasizes that a key issue is whether the Takaichi administration can quell the increasingly influential LDP reflation advocates (who are becoming a force difficult to control), and ahead of the November 21 stimulus announcement, downplay the impression that “purely pursuing size” is the only consideration.

Meanwhile, Nomura also notes that in the meeting between Prime Minister Sanae Takaichi and BOJ Governor Kazuo Ueda, the government conveyed support for the Bank of Japan’s rate hike stance, at least without making statements aiming to delay early rate hikes.

Normally, this would suffice in clearing the way for central bank rate hikes. But worries over increased government spending have pressured the market; unless the government issues clearer statements outlining its support for rate hikes and efforts to stem yen weakness, these concerns are unlikely to dissipate.

The report points out that market reactions confirm insufficient communication: after the meeting, OIS market pricing for rate hike expectations did not change, the yen continued to fall, partly due to abated overseas risk-aversion, with USD/JPY reaching the 155.5-156.0 range. On rate hike expectations, the probability of a hike in December is 29%, and in January is 65%.

Room for Further Ultra-Long-Term Bond Supply-Demand Deterioration

Nomura believes that if ultra-long-term bond supply-demand further deteriorates, the yield curve still has considerable room to steepen. Curve steepening driven by fiscal worries has not yet fully reflected the extent of ultra-long-term bond supply-demand deterioration seen in April-May.

According to Nomura’s analysis, the 30-year Japanese government bond yield can be measured by the 10-30 year OIS spread (term premium) and the 10-30 year box spread (ultra-long bond supply-demand premium). The former reflects premiums brought about by higher growth and inflation expectations and uncertain outlooks; the latter reflects a pure supply-demand deterioration premium.

Comparative data show that during the sharp ultra-long bond supply-demand deterioration in April-May, the box spread widened to 67 basis points; currently it is 48 basis points.

Since the abolishment of Yield Curve Control (YCC), the average has been 45 basis points, with a range of 25-67 basis points. This means that if foreign investors’ selling of Japanese bonds truly deteriorates ultra-long bond supply and demand, this premium could further expand.

Vishnu Varathan, Head of Economics & Strategy at Mizuho Bank, highlights the current abnormal market combination:

“Even though yields are rising, the yen’s performance is still poor.”

This unconventional market behavior reflects investors’ deep concerns over Japan’s policy outlook. Analysis notes that avoiding a Japanese “Truss shock” hinges on whether the government can strike a balance between stimulating the economy and maintaining fiscal credibility.

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