In the global bond market storm, "high-rate economics" becomes the latest weak point: Japan's response options are limited

According to Zhihui Finance APP, Japan is running out of options to cope with the bond market crash, which may cause debt financing costs to exceed the government's expectations and constrain Prime Minister Sanae Takamichi's ambitious spending plans due to uncontrollable factors. Analysts say that the current tools available to stabilize the market—sporadic cuts in bond issuance or emergency central bank purchases—are merely temporary remedies for a bond market squeezed by stubborn inflation and increasingly loose fiscal policy.

Mari Iwashita, Executive Rates Strategist at Nomura Securities, stated, "Since the last oil crisis, Japan has never experienced such persistent price pressures. Anchoring inflation at the Bank of Japan's 2% target level is becoming increasingly challenging."

The center of the global bond sell-off is Japan, with the benchmark Japanese 10-year government bond yield on the verge of breaking through 3%, which would be the first time since the mid-1990s. Investors are increasingly concerned about Japan’s massive debt and inflation risks brought by the Middle East war. On Tuesday, Japan’s 10-year government bond yield hit a 30-year high of 2.945%, and on Wednesday it slipped to around 2.89%.

Although government subsidies have kept core inflation below the 2% target, the Bank of Japan has warned of the risk of overshooting inflation, which might require earlier rate hikes. Expectations for faster and earlier rate increases have alleviated concerns about the BOJ being behind the curve on inflation, but analysts point out that this has also triggered a repricing in the bond market. Investors now see a high chance that rates will reach 2%, much higher than the previously expected peak near 1.5%.

Severe Test

Soaring yields are becoming a severe test for Sanae Takamichi’s economic strategy. She believes the case for increased spending is that economic growth will outpace long-term borrowing costs, allowing Japan to sustain its enormous debt burden without jeopardizing fiscal stability.

If 10-year Japanese government bond yields exceed 3% while inflation remains at 2%, and the real growth rate hovers around just 1% at most, this premise will come into question. In estimates released by the Japanese government in July, real GDP growth for the fiscal year ending March 2027 is projected to be 0.9%, and 1.1% for the next fiscal year.

Higher yields also threaten the affordability of Takamichi’s key economic growth initiatives. Meanwhile, conservatives within the ruling party are urging her to cut spending.

If interest rates remain above 3% (the level taken as a budget assumption), debt financing costs would soar well above the current allocation of 31 trillion yen ($195 billion), while weakening Takamichi's hallmark initiatives to channel investment into growth sectors.

According to benchmark estimates by the ministry, if the yield on Japan’s 10-year government bonds rises to 3.6% in fiscal 2029, the debt service cost that year would surge to 41 trillion yen.

Worse, the government has ruled out setting a cap on spending requests for strategic growth sectors in next year’s budget, a move that may force the government to issue further debt on a revenue base already hit by plans to cut the food tax.

Key Government Responses

Amid continued turmoil in the bond market, there is growing scrutiny of whether policymakers have credible options to curb the sell-off. Analysts say the Ministry of Finance may temporarily cut back on bond issuance or listen to investor concerns about oversupply at a routine meeting next month.

Ataru Okumura, Chief Rates Strategist at SMBC Nikko Securities, said, “Adjusting the timing of bond issuance and making it less regular can help suppress the rise in yields.” In addition, any signals that the ministry may consider cutting 10-year bond issuance are worth watching.

Another option is for the Bank of Japan to intensify emergency bond purchases in the market. Even as it gradually scales back purchase volumes, the BOJ has retained this tool to deal with sharp and disorderly surges in yields that threaten financial stability.

A source familiar with the BOJ’s thinking said that while the central bank has not entirely ruled out the possibility of intervention, given that the recent rise in yields is driven by fundamental factors, the BOJ may feel there is no need to step in for now.

Many analysts believe that unless the government reconsiders its approach of relying on subsidies and tax cuts to ease cost-of-living pressures, yields will remain under upward pressure, as the expansionary measures only stimulate demand and inflation.

Naomi Muguruma, Chief Bond Strategist at Mitsubishi UFJ Morgan Stanley Securities, said, “If the government increases fiscal spending and intensifies price pressures brought by the Middle East war, the Bank of Japan will not be able to anchor inflation expectations. Inflation has now become the main risk for anyone trading Japanese government bonds. The core issue is the market’s doubts about the government’s resolve to control inflation.”