Chapter 1 1.6

Why Yield Curves Matter

Understanding why the yield curve is the foundation of modern finance and economy of Japan

Benchmarking All Other Interest Rates

JGB yields serve as the risk-free baseline for pricing all other Japanese assets. Every risky investment can be valued as:

\[\text{Asset Yield} = \text{JGB Yield} + \text{Risk Premium}\]

Examples:

  • Corporate Bonds: A BBB-rated Japanese corporate bond might trade at "10-year JGB + 150 basis points." If the 10-year JGB yield is 1.5%, the corporate bond yields 3.0%.
  • Mortgages: Japanese mortgage rates are typically priced as a spread over JGBs. When JGB yields rise, mortgage rates follow, affecting housing affordability.
  • Bank Lending Rates: Commercial loan pricing often references JGB yields plus a credit spread based on borrower quality.

How JGB Yields Impact Everyone

Bond yields, especially the 10-year benchmark, act as a reference rate for the entire economy. Their movements directly impact everyone:

  1. Corporate Borrowing: Companies' bond yields and loan rates are priced as "JGB + spread".
    • If 10-year JGB yields 1.5%, a BBB-rated company might pay 3.5% (JGB + 2%). When JGB yields rise, borrowing costs for all companies rise.
  2. Mortgage Rates: Home loan rates are typically based on longer-term JGB yields.
    • Rising JGB yields → higher mortgage costs → impacts the housing market.
  3. Bank Profitability: Banks earn money by borrowing short-term (deposits) and lending long-term (loans). The shape of the yield curve (the "spread") is their profit margin.
    • A steep curve is good for banks; a flat or inverted curve crushes their profits.
  4. Pension & Insurance: These institutions invest heavily in JGBs.
    • Yield levels determine their returns and ability to meet future obligations to retirees and policyholders.
  5. Currency Exchange Rates: JGB yields relative to U.S. Treasury or German Bund yields influence JPY exchange rates.
    • Higher JGB yields (relative to others) → stronger yen, all else equal.
  6. Government Fiscal Sustainability: With debt exceeding 260% of GDP, even small yield changes have massive budget impacts.
    • A 1% increase in average borrowing costs could add tens of trillions of yen to annual debt service.

References

  1. Bank of Japan. "Yield Curve Control." Available at: https://www.boj.or.jp/en/mopo/outline/qqe.htm.
  2. Japan Ministry of Finance. "JGB Interest Rate Data." Available at: https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm.