Pelletier: Many investors remain unaware of the scale of the unfolding bond crisis

May 26, 2025

Martin Pelletier: The next phase of financial instability may be driven by weakness in sovereign debt markets

The Federal Reserve’s uncertain monetary policy and growing fiscal instability have further contributed to higher risk premiums for U.S. long-term Treasuries. Photo by Andrew Harrer/Bloomberg

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The global bond market is facing increasing turmoil, with long-term yields rising across major economies and governments struggling to manage growing debt burdens. Many investors remain unaware of the scale of this unfolding crisis, but recent developments suggest the next phase of financial instability may be driven by weakness in sovereign debt markets.

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Japan’s bond market under pressure

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Japan’s 30-year government bond yield surged to an all-time high last week of 3.14 per cent, following a weak bond auction that highlighted investor concerns over the country’s fiscal stability. The 40-year yield also hit a record 3.6 per cent, reflecting broader unease about Japan’s ability to manage debt without causing market disruptions.

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The Bank of Japan (BOJ) is now stuck in a dilemma. If it raises interest rates to defend the yen or combat inflation it risks increasing debt servicing costs, which could exceed 30 trillion yen (about $289 billion) in fiscal 2025 if rates rise just one per cent beyond expectations. Conversely, keeping rates low risks destabilizing Japan’s bond market, as investor demand for long-term Japanese government bonds has weakened significantly.

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This may have implications reaching beyond its borders as Japan holds about US$1.13 trillion in U.S. Treasuries, making it the largest foreign holder of U.S. debt. Japanese institutions had already sold off US$119.3 billion worth of U.S. Treasuries in just one quarter, marking the steepest quarterly decline since 2012. This suggests Japan may be offloading U.S. debt to fund domestic obligations or defend the yen, potentially triggering broader market shocks.

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U.S. Treasury demand weakens

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The situation in Japan is mirrored in the United States, where Treasury auctions are also showing signs of strain. A US$16 billion auction of 20-year Treasury bonds last week saw weaker-than-expected demand, forcing yields higher. The 30-year Treasury yield breached five per cent, reflecting concerns over rising deficits and long-term borrowing capacity.

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As a result, Moody’s downgraded its U.S. debt rating, which has intensified investor skepticism. The Federal Reserve’s uncertain monetary policy and growing fiscal instability have further contributed to higher risk premiums for U.S. long-term Treasuries. As confidence in government debt declines, borrowing costs could rise, further exacerbating deficit concerns.

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Governments’ spending problem

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Despite growing pressure from bond markets, governments continue to resist spending cuts. The United States leads in deficit spending, with a deficit that was equivalent to 6.4 per cent of GDP in 2024, according to the U.S. Congressional Budget Office. This is compared to other larger economies, according to Trading Economics, such as France (5.8 per cent of GDP in 2024), the United Kingdom (4.8 per cent in 2024) and Germany (2.8 per cent in 2024). Canada’s deficit to GDP ratio was two per cent, according to the government’s 2024 Fall Economic Statement. Interestingly some countries have moved toward budget surpluses, such Norway, with -13.20 per cent of GDP in 2024 according to Trading Economics, showing that fiscal discipline is possible despite global headwinds.