Japan’s Economy Unexpectedly “Hits the Brakes”! Q2 GDP Grows Only 1.1% While 10-Year JGB Yield Surges to 30-Year High

According to Zhitong Finance APP, due to uncertainties arising from geopolitical conflicts in the Middle East, Japan's capital expenditure has remained sluggish, resulting in an unexpected slowdown in Japan's economic growth in the three months up to June. This development may complicate the Bank of Japan's policy communication as it considers the timing of its next rate hike. Data released by the Japanese Cabinet Office on Monday showed that Japan's real GDP grew at an annualized rate of 1.1% in the second quarter. This growth rate is well below the revised 1.9% in the previous quarter and also significantly lags the unanimous market forecast of a 2% annualized rate by Japanese economists, but still marks the third consecutive quarter of expansion for Japan's economy.

Additionally, capital investment in Japan decreased by 1.2% on a non-annualized basis in the second quarter, a larger decline than the revised 1% drop in the previous quarter and significantly below market expectations for a 0.5% increase.

This GDP data marginally weakens the Bank of Japan's "growth permission" for an immediate rate hike in September, but it is not enough to overturn the main trajectory toward tightening. Japan's annualized GDP growth in Q2 was only 1.1%, lower than the market's anticipated 2.0%. Private consumption was flat quarter-on-quarter, and capital expenditure declined by 1.2%, indicating that domestic demand—especially corporate investment—is being hit by high energy costs and the impact of the Middle East conflict. Therefore, if the BOJ considers only the demand side, it has every reason to postpone the next rate hike to October or even later.

However, the main issue is that the BOJ is currently not facing typical demand overheating, but rather a combination of yen weakness, imported energy shocks, rising corporate prices, and elevated inflation expectations. On August 14, media sources cited insiders as saying that the BOJ had discussed the possibility of hiking rates again as early as September 17–18, with the market once pricing in an 80% probability for a rate hike in September. Weak GDP data is more likely to convert the September hike from a "high certainty trade" back to a data-dependent decision.

More concerning is that the yield on 10-year Japanese government bonds, even against a weak GDP backdrop, has retouched around 2.90%, the highest level since September 1996. This suggests that the rise in long-term rates is no longer just about "betting on BOJ rate hikes," but is also pricing in inflation risks, fiscal supply, and much more extreme term premiums.

Naoki Hattori, Chief Japan Economist at Mizuho Research Institute, stated, "In terms of capital expenditure, our base case is that investment remains solid, especially in areas such as artificial intelligence and data centers. However, some small and medium-sized firms may have taken a wait-and-see approach, and heightened uncertainties due to tensions in the Middle East could lead some companies to shelve investment plans."

Japan's Economy Unexpectedly 'Hits the Brakes'! Bank of Japan’s 'September Rate Hike' Shifts from Certainty to Data-Driven Gamble

Keiji Kanda, Chief Economist at Daiwa Institute of Research, said, "Consumption is quite weak. The drop in non-durable goods was larger than expected. Considering that consumption is not as robust as anticipated and capital expenditure is also soft, I don't think the overall results can be considered particularly strong."

As shown above, Japan's economy unexpectedly slowed down—amid Middle East tensions, Japan’s growth rate decelerated.

This data release comes at a time when Japan’s economy is feeling the impacts of the Middle East conflict. The tensions have pushed up the prices of fuel and petrochemical products, while also disrupting some supply chains. The unexpected slowdown could complicate the Bank of Japan’s policy communication as it weighs the timing of its next rate hike.

Based on overnight swap market pricing as of Monday morning, interest rate futures traders see an 80% chance that the Bank of Japan will raise its benchmark rate at its next monetary policy meeting on September 18.

Among other factors dragging down economic growth, private consumption was flat quarter-on-quarter, below the market consensus for a 0.4% increase. In the previous quarter, private consumption had grown by 0.5% after revisions. This likely reflects that consumers’ willingness to shop has generally weakened amid rising living costs.

Signs of weak domestic demand in Japan will be concerning for Prime Minister Sanae Takai. About six months ago, she had just won an overwhelming electoral victory, but as consumers continue to face continuous increases in prices for daily necessities such as food, her approval rating has begun to fall. The Takai government has already rolled out subsidies to cap public utility costs and now plans to cut the food consumption tax to 1% for two years starting next April.

"Japan’s second-quarter GDP growth exceeded its potential rate, but the breakdown weakens the case for the Bank of Japan to hike in September—a move the market had increasingly priced in. The drop in capital expenditure may indicate that, as crude oil prices are squeezed by the war in Iran, companies are turning more cautious about future growth prospects," said Taro Kimura, Senior Economist at Bloomberg Economics.

The GDP data contrasts somewhat with a series of generally optimistic corporate data released in parallel. The Bank of Japan’s Tankan survey showed that in June, business confidence among large manufacturers rose to its highest level since 2018, fueled by demand for AI computing power and boom in AI infrastructure, while confidence among large non-manufacturers related to servers remained near its highest levels since 1991.

Since the end of Q1, Japan's industrial output has grown month by month, with forecasts for July and August output to increase further. At the same time, Japan’s manufacturing PMI remains elevated, having reached a 12-year high in April.

Despite corporate earnings remaining relatively strong, business investment has still declined. In the three months to March, corporate ordinary profits had posted a much larger year-on-year increase than the market expected.

To be sure, companies are facing higher operating costs. In July, corporate goods prices continued to rise at a brisk pace, up 7.2% year-on-year, forcing firms to consider further passing on costs to clients by raising prices.

With the Strait of Hormuz effectively remaining closed, the Japanese government has been seeking to diversify energy sources to ease tight conditions in the energy market. June trade data shows that U.S. crude oil now accounts for nearly a third of Japan’s oil imports, compared with only about 7% in February.

Looking ahead, Japan’s economy faces both tailwinds and headwinds. However, economists say that robust wage increases driven by annual wage negotiations and government subsidies are still expected to support household consumption spending.

Kanda said, “Consumer spending was weaker than expected, but employee compensation increased compared to the previous quarter, and real wages are still growing year-on-year. Therefore, taking all these factors into account, I don't think the underlying economic recovery trend in Japan has been undermined.”

Following the data release, the yen strengthened slightly, rising to 159.04 from about 159.21 before the release. Since the Japanese and U.S. governments intervened to support the yen at the end of July, the yen’s appreciation has narrowed, remaining well below its 10-year average level of 126.09.

GDP Cools Unexpectedly, But 10-Year JGB Yield Surges to 30-Year High!

This GDP data marginally weakens the BOJ's "growth permission" for an immediate September rate hike, but it is not enough to overturn the tightening trend. Japan's annualized GDP growth in the second quarter was only 1.1%, lower than the anticipated 2.0%. Private consumption was flat, and capital expenditure unexpectedly slumped by 1.2%, suggesting that domestic demand—especially corporate investment—is being hit by high energy costs and the Middle East conflict. Therefore, if the BOJ were to focus solely on demand, it fully justifies postponing the next hike to October or later.

However, the current problem facing the BOJ is not typical demand overheating but yen weakness, imported energy shocks brought by Middle East geopolitical tensions, rising corporate prices, and elevated inflation expectations. The BOJ has already discussed the possibility of rate hikes as early as September 17–18, with the market previously pricing in an 80% probability for a September hike.

Weak GDP makes a September hike more likely to shift from a "high certainty trade" to a data-dependent decision, rather than ending the tightening cycle itself. Japan's bond market benchmark risk-free rate—the 10-year JGB yield—has re-approached the strong level of about 2.90% in a weak GDP backdrop, reaching its highest region since September 1996. This also suggests that the increase in long-term yields is no longer just about pricing in BOJ rate hikes, but is also trading inflation risks, fiscal supply, and term premium.

The Takai government’s expansionary fiscal plans, public debt exceeding 200% of GDP, rising energy import costs, and the BOJ's ongoing reduction in bond purchases all demand that investors command a higher term premium for holding long-dated JGBs, with the 3% level already seen by some market participants as a potential trigger for a new round of selling. Weak GDP may dampen expectations for short-term rate hikes, but may not lower long-end yields—Japan is experiencing a classic "growth slowdown, still hawkish policy, and rising long bond yields due to fiscal and inflation premium" steepening risk. If the September hike is postponed but the 10-year yield remains anchored between 2.8%–3%, it would indicate that the bond market’s concern has shifted from "BOJ rates" to a repricing of Japan’s long-term fiscal and inflation credibility.