Japan faces a complex fiscal test with the 10-year government bond yield approaching 3 percent, at a time when inflation fears are increasing and pressures on the public budget are expanding. Which threatens to undermine part of the ambitious spending program adopted by Prime Minister Sanae Takaichi.
After more than a decade in which the Japanese bond market was synonymous with low yields and ultra-loose monetary policy, the landscape has changed rapidly. The yield on 10-year bonds reached 2.945 percent on Tuesday, the highest level in 3 decades, before falling to about 2.89 percent on Wednesday.
Analysts say that the current wave does not merely reflect short-term speculation, but also reflects a deeper shift in risk assessment, in light of more difficult inflation, rising energy prices due to the war in the Middle East, and rising expectations that the Bank of Japan may accelerate the pace of raising interest rates.
“Japan has not witnessed price pressures this persistent since the previous oil shock,” said Mary Iwashita, chief interest rate strategist at Nomura Securities, noting that keeping inflation close to the Bank of Japan’s two percent target has become more difficult.
Although government support kept some core inflation measures below the two percent level, the Central Bank itself warned of the possibility of inflation exceeding the target. Which increased speculation about raising interest rates sooner and at a faster pace.
Investors now see a potential path for interest rates to reach 2 percent, compared to previous estimates that indicated a peak near 1.5 percent. This shift alone is enough to repricing the entire yield curve and raise the cost of government borrowing.
The sensitivity of the 3 percent level is that it is more than a psychological barrier to the market; It directly touches on the government's financial assumptions. Takaichi's economic strategy is based on the idea that economic growth will remain higher than the long-term cost of borrowing, allowing Japan to finance new investments and continue to service its huge debt without losing control of public finances.
But this hypothesis becomes even more fragile if the 10-year bond yield exceeds 3 percent sustainably, inflation hovers around 2 percent, and real growth is expected to remain near 1 percent.
The government expects real GDP to grow by 0.9 percent during the fiscal year ending in March 2027, then 1.1 percent during the following year. In contrast, the government has currently allocated about 31 trillion yen, or about $195 billion, to debt service. If revenues rise above the level on which the budget was based, this bill will increase quickly.
According to the Ministry of Finance's basic scenario, if the 10-year bond yield reaches 3.6 percent during fiscal year 2029, the cost of debt service will rise to about 41 trillion yen, an increase of about 10 trillion yen over the current level.
The pressure is increasing because the government has refused to set a ceiling on spending on requests from strategic sectors in next year's budget, while it is also seeking to implement tax cuts on food. This means the possibility of increased bond issuance to compensate for lost revenues and finance growth programs, which in turn could increase the supply of debt and further pressure prices and raise yields.
Takaichi is also facing pressure from within the ruling party itself, where a more fiscally conservative wing calls for controlling spending and limiting the expansion of the deficit. The government thus becomes stuck in a complex loop: rising costs of living prompt it to increase subsidies and reduce taxes, but these policies are expansionary and may fuel demand and inflation, which then leads to higher yields and increases the cost of servicing the debt.
As for the tools available to calm the market, they are limited and temporary in the eyes of analysts. One option is for the Ministry of Finance to adjust the bond issuance schedule, or exceptionally reduce issuances at some deadlines, especially 10-year bonds, if it believes that the market is facing an oversupply.
Ataru Okumura, chief interest rate strategist at SMBC Nikko Securities, said that adjusting bond issuance at an unusual time may help curb the rise in yields, especially if it is accompanied by a clear indication of the ministry’s willingness to reduce issuance at some deadlines.
The second option is for the Bank of Japan to intervene through emergency purchases of bonds if the market witnesses rapid and irregular movements that threaten financial stability. The Bank retained this tool even as it began reducing its massive purchases of government bonds, but the current timing does not seem appropriate to return to broad purchasing.
The most difficult paradox for the Bank of Japan is that any significant increase in bond purchases to reduce yields may conflict with the path of monetary policy normalization, and send a confusing message to the markets at a time when the Bank is trying to curb inflation.
Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, said the Bank of Japan cannot stabilize inflation expectations if the government expands spending and adds more price pressures to those resulting from the Middle East war.
Ultimately, the markets seem to be sending a clear message to Tokyo; Japan is no longer able to deal with rising spending and the cost of debt, as if the low-interest era was still in place.
The Bank of England faces a new test in the fight against inflation, with energy prices returning to pressure on the cost of living in Britain, at a time when the repercussions of the Iran war are still casting a shadow on global energy markets.
The importance of rising energy bills is not limited to its direct impact on inflation; Rather, it extends to the risk of the wave of high prices spreading to other sectors, which may put the bank facing a difficult equation between containing price pressures and maintaining economic momentum.
During July, data from the British Office for National Statistics showed that inflation rose to the highest level in 4 months, to 2.9 percent in July, from 2.6 percent in June, which is the lowest level in 15 months.
The rise comes after the British Energy Regulatory Authority (Ofgem) raised the maximum limit that energy companies are allowed to impose on households by about 13 percent at the beginning of July, which led to a sharp increase in gas and electricity prices.
The July figures largely reflect the impact of the energy shock related to the war in Iran and turmoil in global energy markets. The war has led to rising gas and oil costs, at a time when shipping traffic in the region is facing disruptions.
Finance Minister John Healy said, after the release of the data, that “Iran war inflation” is still affecting prices at home, but he stressed that the British economy is “resilient,” adding that there is more work to do to restore hope and build a stronger economy.
Despite the rise in general inflation, some of the most important indicators for monetary policy showed that domestic pressures are not accelerating at the same pace. Core inflation, which excludes energy and food prices, stabilized at 2.6 percent in July, compared with June.
The inflation data comes after indicators released on Tuesday showed a slowdown in the labor market, with wage growth declining and job vacancies falling to the lowest level in 5 years. Separate data also showed that the median increase in workers' wages granted by British companies amounted to 3.2 percent, the weakest since September.
This time, the Bank of England is trying to avoid a repeat of the 2022 experience, when the energy shock resulting from the Russian invasion of Ukraine, in conjunction with the strength of the labor market after the “Covid” pandemic, pushed British inflation to more than 11 percent.
The July data puts the bank in front of a delicate equation: raising interest rates to confront a temporary energy shock may put pressure on the economy and the labor market, while ignoring the continued rise in prices may increase the risks of entrenched inflation.
