Moody’s downgrade of its rating of American government debt by one notch, to the second-highest mark of Aa1 from the highest of all, AAA, is not causing too many market ripples, and nor should it.

Fellow ratings agency Standard & Poor’s made this move back in 2011, after all, and Moody’s action reflects the issues which are obvious to even the more casual observer: America’s federal debt is $36 trillion and going higher, especially if president Donald Trump’s ‘One Big Beautiful Bill’ extended tax breaks and introduces new ones. The annual interest bill is $1.1 trillion, or a painful one fifth of the tax take; and half of the debt has to be refinanced within three years, almost certainly at higher rates of interest, to make the first two sets of figures even worse.

In this respect, Moody’s actions are simply an example of a well-known phrase that involves words like horse, door, stable and bolt. As such, investors may be better off watching events in the Japanese government debt markets, rather than the American ones, at least for now, because what is happening in Tokyo could prove to the template for Washington in the fullness of time.

HIGHER YIELDS

Japanese government bonds or JGBs for short have the nickname ‘the widow maker,’ because those who have tried to bet against them, in the view yields would rise and prices would fall, have generally met a very sticky end for much of the last 30 or 40 years. For much of the time since a debt-fuelled equity and property bubble burst in 1989, Japan has suffered deflation, or at least disinflation, and unsuccessful attempts at fiscal stimulus have simply ramped up the debt-to-GDP ratio to 235%. In its attempts to head off disaster, the Bank of Japan has kept interest rates near, or below, zero and massively expanded its balance sheet, as it ran countless quantitative easing (QE) programmes and printed yen.

But now everything seems to be changing.

Thanks in part to the supply chain dislocations caused by Covid-19 and lockdowns, in combination with fiscal and monetary stimulus, Japan’s inflation rate now exceeds that of the US, EU and UK. (A surge in the price of rice, a staple food, is not helping either). In response, the Bank of Japan is now raising interest rates and starting to embark upon quantitative tightening.

This is all making the nugatory yields available on JGBs look very poor value indeed and markets are taking evasive action as a result. Yields are rising, especially on longer-dated paper, as can be seen most spectacularly in the case of the 30-year JGB.

RISING YEN

Those higher yields are tempting in some buyers, with the result that the yen is rising, albeit at a bad time for Japanese exporters, who are already facing the challenge to their competitiveness posed by president Trump’s tariffs. This combination means Japanese GDP shrank by 0.2% in the first quarter, something that will not help the tax take or the national debt.

Japan’s prime minister, Shigeru Ishiba, may be over-egging it when he says Japan’s situation is worse than that of Greece over a decade ago, even if Athens’ debt-to-GDP ratio was ‘only’ 180% when it faced an economic crisis in the 2010s. Japan has an independent central bank and has substantial foreign reserves, such as large holdings of US treasuries, that it can sell to influence its own currency’s level. It also has an array of top-class exporters who can support growth.

But the JGB market is clearly concerned, and this shows what just could happen in the US if its federal debt starts to get out of hand, or investors lose a little faith in holding dollar-denominated assets for whatever reason (such as a capricious presidency, for example).

SUMMER SQUALL

Investors may also remember how an unexpected bout of yen strength was offered as one potential explanation for last August’s (short-lived) stock market stumble.

The Japanese currency had been a major source of global liquidity, as major market players have shorted it, borrowed against it and used that money to go long risk assets around the globe. Higher rates and QT are turning off the tap. The more the yen rallies, the more short positions against it may have to close, to drive the currency higher still and force yet more liquidation by the shorts. That would create a circle every bit as vicious as it had previously been virtuous.

Events in Tokyo could yet have a wider bearing on the world and its currency, bond and stock markets.

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