RPT-ROI-Japan fiscal experiment is lab test for Treasuries: Mike Dolan

By Mike Dolan

LONDON, Nov 24 (Reuters) - Much has been made of whether Japan's market fright at yet more fiscal stimulus and political leaning on the central bank apes Britain's bond blowout from 2022, but there are warnings for the U.S. Treasury too.

In an unusual and alarming pattern that often suggests capital flight concerns, Japan's government bond prices and the yen fell sharply in tandem last week as new Prime Minister Sanae Takaichi boosted spending while pressuring the Bank of Japan to maintain easy monetary policy despite rising debt and inflation.

As rising bond yields typically support a currency with the promise of higher returns, the sight of the yen falling even as borrowing rates climbed raised the spectre of capital flight. That was something Britain experienced, albeit briefly, after the disastrous 2022 budget of unfunded tax cuts under former Prime Minister Liz Truss.

Talk of a "Truss moment" in Japan has obvious comparisons but also differences - not least the reaction function of the two central banks but also the fact Japan has a surplus of investment capital and the UK runs a chronic deficit.

And yet market experience was similar - hinged on fears of an exit of domestic money from Japanese long bonds while worries of foreign funds balking at "gilts" abounded three years ago.

UK gilts are on edge again this week as the government outlines its latest budget on Thursday. While the backdrop of relatively tight fiscal and monetary policy is different this time around, the political risks for the ruling Labour Party surrounding more tax rises jar some nerves.

Those twin tracks of loose fiscal policy and compromised central bank independence perhaps speak just as clearly to what may be coming down the pike in America and whether U.S. markets may yet react as they have done lately in Japan.

There was such a "moment" in April this year, of course. As the trade tariff shock hit, the dollar, Treasury prices and stock markets all fell together for a brief period and investors have fretted about such a threat to Treasuries ever since.

WILL FED 'CAPTURE' BE A MOMENT?

A theme of the early part of 2026 at least will be President Donald Trump's replacement of Federal Reserve Chair Jerome Powell when his term expires in May, along with likely attempts to fill any Fed board seats available or even replace regional Fed chiefs with officials sympathetic to his wish to floor interest rates sharply.

Even though pressure on the Bank of Japan is about Takaichi leaning against higher interest rates whereas Trump's push is for the Fed to speed up deeper rate cuts, the common factor is that both are pressing for easy money even as inflation runs hot and government borrowing builds.

Trump won't be repeating this year's "One Big Beautiful Bill" and he claims tariff revenues and faster growth will keep still-high deficits in hand. But he has floated the idea of a fresh round of stimulus checks for households and questions about future tariff math abound.

Along with rising nominal yields, so-called term premiums on long-dated Japanese government debt, which capture investor uncertainty around everything from the long-term inflation horizon to debt sustainability, have soared of late.

Treasury equivalents rose earlier this year too, but have stabilized since as the fiscal picture improved somewhat, tariff hits to inflation were below forecasts, growth held up and deregulation held the prospect of more bond demand from banks.

But sentiment around "fiscal dominance" remains fragile.

IS THE US A SPECIAL CASE?

The resumption of Fed gradual easing and the ending of its balance sheet rundown has helped Treasuries hold the line. Even recent Fed caution about not easing too fast with inflation still high may also have cosseted faith in an "old Fed" commitment to the 2% inflation target.

What's more, the gigantic near $30 trillion Treasury market remains a special case given its centrality to global finance and the dollar's still dominant role in the banking of global savings. The stakes around dollar credibility are high in that regard.

One could also make the argument that if global "safe" bonds around the world are all restive, then that centrality of Treasuries makes them a marginal winner. Japan, France and Britain have all had significant jolts since April's wobble in Treasuries.

But equally, "safe" bonds tend to be held in buckets and correlate to some degree - mainly as sovereign investors and central bank reserve managers tend to match holdings to the four dominant reserve currencies of the dollar, euro, yen and sterling.

A disturbance in any one could potentially have spillovers to the others for that reason.

While each of these bond markets has had its "moment" this year, they have all seen a sharp steepening of yield curves between short-dated debt and long-term multi-decade tenures. In some respects, that's been the fixed income trade of the year and will likely remain so in 2026.

Whether a more serious confluence of currency and bond selling that Japan has endured of late infects Treasuries next year likely then hinges mostly on political moves on the Fed.

If markets suspect an acceleration of rate cuts after May without commensurate improvement in inflation, they may be on high alert for another "moment".

The opinions expressed here are those of the author, a columnist for Reuters

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