Liz Truss’s 49-day tenure as prime minister left her little time to put her stamp on the UK economy. Markets reacted sharply to her “mini” Budget plans; a £60bn package of tax cuts was swiftly abandoned as gilt yields soared and the value of the pound plummeted.
The episode marked a break from expected market behaviour: usually, the forces that push bond yields higher (such as rising interest rates) would also support a stronger currency. But in 2022, the opposite happened. Analysts coined the term “moron risk premium” to describe the extra interest that investors demanded in the face of unpredictable UK fiscal policy. And it endures as an unflattering legacy of the Truss/Kwarteng government: economists are still getting plenty of use out of the term today.
Are high Japanese government debt levels unsettling investors?
At the time of the “mini” Budget, UK government debt stood at 90 per cent of GDP – and was poised to rise even further if the new measures came in. Though reaching 100 per cent sounds totemic, there is no single threshold over which government borrowing becomes unsustainable. In Japan, debt is well over 200 per cent of GDP thanks to 30 years of expansionary policy in the face of stubbornly slow economic growth.
As the chart below shows, yields don’t always rise in the face of generous policy spending. Japanese government borrowing costs were very low for years, helped by an unconventional monetary policy stance. Under its yield curve control framework, the Bank of Japan bought and sold bonds to anchor long-term rates. The policy has since been phased out as the economy started to normalise. Inflation and wage growth have picked up, prompting a gradual rise in interest rates to 0.75 per cent.
This month, Japanese 10-year bond yields rose to over 2.3 per cent as Prime Minister Sanae Takaichi called a snap election in an attempt to strengthen her mandate. After weeks of conflicting messages, she also announced a suspension of sales taxes on groceries and drinks, which will cost the equivalent of £24bn a year, or 0.8 per cent of GDP. Markets were unsettled and, in an echo of the “mini” Budget, the value of the yen also fell. Speculation began to mount that the Japanese government could be forced to cough up a “moron premium” of its own.
A new normal?
Yet research suggests a more reassuring explanation for rising yields. Capital Economics estimates that of the current 2.3 per cent 10-year bond yield, 2 percentage points reflect expected inflation. This suggests that investors are pricing in economic normalisation, rather than ‘moronic’ policymaking. But policy changes could still trigger significant shifts. Faced with years of meagre returns from domestic bonds, Japanese investors long ago decided to park their money elsewhere. As a result, the country’s net international assets are the largest in the world, with a significant share invested in the US.
As the gap between US and Japanese bond yields closes (see chart), could capital return home? Bearish analysts see a scenario where Japanese demand for Treasuries drops, pushing up US yields – with the higher borrowing costs tightening financial conditions worldwide. This is probably overblown: unpredictable fiscal policy at home might make Japanese investors less likely to move into domestic government bonds, even if yields look tempting. The smaller and less liquid Japanese bond market could struggle to absorb the demand in any case.
But credibility still matters. US Treasury yields also ticked up last week following renewed tariff uncertainty. Like the UK, the US relies on overseas buyers for around 30 per cent of its government bonds. In the face of unpredictable policy, even safe-haven assets can find that investors demand a premium.