Japan's problems could make the eurozone's look like a garden party

I am sure it is a question that has been repeated in many investment conversations since my previous column a fortnight ago.

Many who ask that question automatically assume, or want to assume, that the impact will be negative. They base this assumption on the persistent mood of doom and gloom that has prevailed since the darkest days of 2008-2009.

It is, of course, a very important question, because long-term bond yields are presumably lower than they would be in a "normal" world and, at some point, if the Western world ever returns to normality, they will rise. Needless to say, we have plenty of evidence from some countries inside the eurozone that they can also rise when things are not so normal.

But there is a big difference between the fact that yields are rising and the reasons behind it. Indeed, after a recent rise in Japan's 10-year bonds to 1pc, the new Bank of Japan governor, Haruhiko Kuroda, argued that if Japanese growth returns to normal, then their economy and system can cope with yields at 3pc. He also pointed out that if yields were to rise without a full-blown recovery, then the consequences for the Japanese banking system would be quite challenging.

Many think that an understatement, given the size of Japan's sovereign debt – around 230pc of GDP – could make the kind of chaos witnessed by some peripheral eurozone countries look like a garden party.

Japan is important because of the size of its economy and debts; its role in investing elsewhere in the world's markets; and because of what it could mean, at some stage, for the UK, the US and possibly others, too.

Since the "shock and awe" that came with the appointment of Kuroda at the BoJ, 10-year bond yields have risen: indeed, their levels last week of around 1pc were actually double the lows reached around the time he was starting his job.

Those most bearish about Japan argue that, contrary to the optimism shown by many commentators and the Japanese stock market, this is indeed the beginning of the end for Japan. They see the start of an uncontrollable decline in the yen and a bigger pick-up in inflation than the BoJ desires, both of which, far from contributing to economic recovery, will actually put Japan into a new, more worrying, phase of economic weakness.

In such a horror scenario, it wouldn't be too much of a stretch to add that major Japanese institutions would either choose, or be forced, to sell many of their foreign assets in order to bring money home, resulting in a major negative phase for many external markets, especially bond markets. Some popular emerging market debt, US Treasuries and a number of European bonds could suffer from such an outcome.

This could be a consequence of Japanese policymakers losing control of their domestic situation, and it is not an impossible outcome, but at this stage, I think it is an unlikely scenario. More feasible is that, as more domestic investors think the authorities are going to succeed with this new policy, bond yields could also rise but in a less damaging way – so long as overall financial conditions remain easier, or ease further.

I believe this to be a crucial point of distinction and I think that many Western central bankers – including some of our own Bank of England members – have misled themselves, as well as others, about measuring the effectiveness of so-called quantitative easing (QE).

Some policymakers, especially in the early days, tried to judge the success of QE by the impact it had on whether long-term bond yields were lower than they would otherwise have been. It always struck me that this was hardly a high hurdle, nor an appropriate one.

In fact, it could be a potentially troublesome criterion once markets believe the economy is starting to do better – as some might now think about Japan – because eventually, if economies return to normal, it would seem quite sensible that bond yields might return to normal.

Most economists would argue normal 10-year bond yields should equate closely to the trend growth rate, plus the inflation performance or underlying inflation expectation, plus some kind of risk premia. So, in an economy where inflation is targeted credibly at 2pc, and the growth trend is 2pc, then 10-year bond yields somewhere at 4pc or above would be normal.

Ultimately, for us here in the UK, 10-year gilt yields between 4pc and 5pc would be normal and, in that sense, would be desirable. Consequently, and in contrast to how some policymakers have measured their policies, I would argue, after each bout of QE, that higher bond yields would be the right yardstick, so long as they were accompanied by stronger equity prices and improved measures of business and consumer confidence.

Returning to Japan and Kuroda's claim that the economy can cope with 3pc yields, the quicker such a move happens, the better for all of us, so long as it is in circumstances of easy overall financial conditions and improving Japanese confidence.

Jim O'Neill is the former head of Goldman Sachs Asset Management

Goay Joe Lie

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