A Japanese Debt Crisis Is Closer Than You Think

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Trump's tariffs , though, have injected extreme uncertainty into global debt markets. And, in Japan's case, an unforced error by outgoing Prime Minister Shigeru Ishiba, who in May said Tokyo's deteriorating finances are“worse than Greece .” The comment made global headlines for all the wrong reasons.

Ishiba was trying to make a more nuanced point, aimed at dissuading lawmakers from cutting taxes to juice GDP. He worries that the step might draw the attention of credit rating companies to Tokyo's precarious finances.

Japan's demographic trajectory hardly helps. Japan's aging, shrinking population features one of the globe's lowest birthrates. In 2024, the population of Japan shrank by 0.75%, the largest drop since records began in 1968.

Around the time Ishiba was comparing Japan to Greece, a routine May 20 sale of $6.9 billion of bonds maturing in 2045 attracted the weakest demand since 2012.

The“tail,” the spread between the average and lowest-accepted price, was the ugliest since 1987. Since then, a series of 20-year, 30-year and 40-year JGBs have been alarmingly undersubscribed.

Part of the problem is how Trump's tariffs are wreaking havoc with US Treasuries and the dollar. That turmoil was one of the key reasons why the BOJ shelved its two-year process of raising rates from zero, at least temporarily.

Now, political uncertainty in Tokyo is raising the stakes. In late July elections, Ishiba's Liberal Democratic Party performed dismally, prompting him to resign earlier this month.

Now, the LDP controls neither house of parliament, forcing the party to partner with pro-tax-cut opposition parties. The specter of fiscal loosening has the bond vigilantes ready to pounce.

A pivot back to aggressive profligacy could make the volatility in Japanese markets seen in May look tame by comparison. That could vastly raise debt borrowing costs for Japan's $4.2 trillion economy .

Analyst Thomas Rookmaaker at Fitch Ratings notes that“higher rates and the Bank of Japan's quantitative tightening will put upward pressure on government borrowing costs.” This helps explain why the BOJ is throttling back on tightening operations.

In July, the BOJ announced plans to slow the pace at which it trims monthly bond purchases to quarterly reductions of 200 billion yen (US$1.36 billion) from 400 billion yen ($2.7 billion). Not everyone agrees this was a wise move.

As Commerzbank economist Michael Pfister points out,“the inflation rate has remained above the 2% target for over three years now, and survey-based inflation expectations have risen significantly again recently.”

Yet many observers point to what's going on with Japan's yield curve. Specifically, how much the 10-year-to-20-year part of the maturity spectrum has risen as the BOJ has tried - with little success - to continue reducing its massive JGB holdings without unnerving the market.

“It's tempting to think that the BOJ can just sit on its holdings if its balance sheet run-off is causing yields to spike,” says Brooks.“But things aren't that simple. The yen has depreciated 25% against the dollar in recent years, as global interest rates have risen. The Bank of Japan is under pressure to catch up to this rise in global yields, for fear that the yen could go into another depreciation spiral.”

Yet the bottom line, Brooks says, is that exceptionally high government debt is putting Japan in a terrible bind. If Japan sticks with low interest rates, it risks further yen depreciation , which could cause inflation to run out of control.

If it anchors the yen by allowing yields to rise further, this could put Japan's debt sustainability at risk.“This Catch-22,” he says,“means a debt crisis is much closer than people think.”

Of course, Brooks concludes,“a debt crisis isn't inevitable. It's possible that the US goes into recession, which will cause US and global yields to fall. That will buy Japan time. But in the end, the only sustainable way out of this Catch-22 is for Japan to cut spending and/or raise taxes.”

Here, the US Federal Reserve's rate decision on Wednesday is important. Fed watchers generally agree that Chair Jerome Powell's board will lower rates by 25 basis points. Yet any hints of bigger reductions on the way could backfire, sending US yields sharply higher.

Oddly, says strategist David Kelly at JPMorgan Asset Management, a Fed rate cut could intensify risks facing global bonds and stocks, given Trump's demands for lower rates.

“To the extent that the Fed's decision this week is seen as a capitulation to political pressure, a new layer of risk is being added to US financial markets and the dollar,” Kelly says. There's little evidence in the Fed's own forecasts for growth and inflation to justify rate cuts, he adds.

“By the fourth quarter of this year, inflation could be 1.2 percentage points above the Fed's target and rising, while unemployment would be just 0.3 percentage points above their target and stable. If this is the outlook, why should the Fed cut at all?”

Trump's campaign to fire Powell - and remove Fed Governor Lisa Cook - is undermining trust in the dollar. As investors and central banks cash out their dollar assets, the fallout on global markets could be extreme. The US Senate, meanwhile, rushed Trump loyalist Stephen Miran onto the Fed Board in time for the September 16-17 policy meeting.

That very likely puts a third dissenting vote in favor of bigger rate cuts on the Federal Open Market Committee. It also likely increases the odds that global markets will view any Fed rate cuts as suspect.