A 20,000-Foot Perspective: Fiscal Policy Takes the Lead

Recent volatility in traditionally “sleepy” Japanese bonds bears watching as fiscal policy becomes the chief policy lever globally; the country’s role as one of the world’s major creditors means that what happens there could have far-reaching impact.

In our last Asset Allocation Outlook—published at the height of tariff-driven market turbulence—we described President Trump’s early trade policies as the “storm before the calm.” Since then, conditions have grown noticeably quieter, particularly in riskier assets.

Yet one corner of financial markets that has flared up is the sovereign bond market. Propelled by an increased focus on fiscal policy as the chief policy lever in many countries, longer-dated developed-market sovereign bonds have risen sharply in the past month or so, led, surprisingly, by a normally “boring” market: Japan.

What are the implications for other regions, and where might this end?

The Four Horsemen of Asset Allocation

While markets may appear calmer on the surface, a closer look reveals a complex set of underlying risks that continue to shape the investment landscape. To navigate this environment over the medium term (i.e., the next 12 – 18 months), we are focused on four key strategic risks—our “Four Horsemen” of asset allocation:

1. Disruption from trade wars: Average U.S. tariffs on the rest of the world are poised to return to levels not seen since the late 1930s. More recently, Section 899 of the “Big Beautiful Bill” has raised the possibility of effectively extending tariffs from goods to services, although these are still early days. The indirect effects of these “wars”—via heightened uncertainty and negative sentiment—may ultimately have a greater impact than the more direct shocks to economic growth and inflation.
2. A rotation toward fiscal from monetary policy: For the first time in decades, governments in many parts of the world are increasingly relying on fiscal measures as their main policy lever. Germany has unlocked a fifth of its GDP in government spending, and the U.S. government (and perhaps that of the U.K.) is quickly reversing course from turning restrictive to delivering additional stimulus. But it is Japan—where the debt burden is among the highest in the world and overwhelmingly owned by the central bank—that is back in sharp focus.
3. Belabored monetary policy: The ability to deploy monetary policy appears particularly challenging in the U.S., where trade-related supply shocks are much harder to manage with central bank tools. This is an important distinction from regions under the purview of the European Central Bank or Bank of England, for example, that are predominantly facing demand shocks from trade wars. To be sure, we, like many others, now see a weaker labor market as key to a prospective “Powell put,” yet labor-market data remains among the most lagging economic indicators. As a result, monetary policy appears to have shifted from a forward-looking to a more reactive, backward-looking stance—a notable departure from past practice.
4. Heightened geopolitical risk: Ongoing conflicts such as Russia-Ukraine, recent tensions between India and Pakistan, and rising instability in the Middle East—particularly involving Iran—underscore the complex geopolitical landscape. Distinguishing between political posturing and meaningful action remains a significant challenge for investors in assessing potential market impacts.

Cue the Second Horseman

With these four “Horsemen” shaping our outlook, it’s the second—fiscal policy’s ascendancy—that has recently come to the fore. Longer-dated yields have moved higher and broken through key levels in areas including the U.S. But the truly eye-catching moves have come from a normally very quiet corner: fixed income in Japan. Indeed, from a 20,000-foot perspective of an asset allocator, this quintessentially “boring” market has charged the global march higher in sovereign bond yields, with parts of the curve (including the 10- to 30-year segment) near their steepest in memory.

What is going on?

On the surface, at a time when fiscal profligacy is in focus, it seems reasonable to expect that Japan, as one of the world’s most indebted economies, would come under some pressure.¹ A prospective doubling of defense spending, from 1.6% to 3% of GDP in a supplementary budget, new solvency ratios for Japanese insurers (that, along with demographics, limit the demand for longer-dated bonds), a few poorly received bond auctions and rising inflation have added fuel to the fire.

The BoJ’s Policy Tightrope

An important difference between Japan and most other developed countries is that, with inflation still trending higher and broadening (with more than 60% of Tokyo’s CPI now above the 2% target) and a low 0.5% policy rate, the Bank of Japan (BoJ) is tightening policy. In fact, the BoJ may be tightening in more ways than has been recognized hitherto.

The BoJ owns a sizable chunk of outstanding Japanese Government Bonds (JGBs): around 52% at the end of 2024, down from a peak of 54% in 3Q 2023. This compares with the Federal Reserve’s 18% ownership of U.S. Treasuries, from a peak of 28%. In the case of Japan, these holdings represent nearly 80% of the assets held by the BoJ, with around JPY 57 trillion ($400 billion) maturing this year.

But the most striking feature of this debt is its duration: The average duration of the BoJ’s book of JGBs has shrunk to just six years, or three years shy of the maturity of the JGB market as a whole. Put differently, the BoJ owns remarkably few long-duration bonds, and so is effectively tightening with one hand while continuing to buy bonds with the other.

There may be wider lessons to be learned from Japan, as large swaths of developed markets rotate toward fiscal and away from monetary policy as their main policy lever. Two stand out: First, necessary bond issuance to fund future spending must be calibrated carefully; we are seeing this in the U.K., for example, with more focus on the belly of the curve. Second, and just as important, central banks must adjust balance-sheet programs in a deliberate manner. Insofar as central banks like the Fed affect the real economy chiefly through financial conditions, moves higher in, say, 30-year bond yields would tighten financial conditions just as the central bank prospectively seeks to ease. Japan is also one of the world’s largest creditors, so what happens there matters for the rest of the world.

There is also, perhaps, a lesson for Japan to learn, with its own version of “Operation Twist.” The BoJ could reinvest proceeds from maturing JGBs further out on the curve, while raising short-term interest rates to quell price pressures. With the bond curve steepening as the central bank hikes policy rates, this seems to be the clear message from markets to Japanese authorities.