The Japanese bond crisis and the challenges of inflation in Britain: financial and monetary tests

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 more fragile if the 10-year bond yield exceeds 3 percent on a sustainable basis, while inflation hovers around 2 percent, and real growth is expected to remain near 1 percent, according to Reuters.

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 government is facing pressure from within the ruling party itself, as 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 to exceptionally reduce issuances at some time.

On the other hand, the Bank of England faces a new test in the fight against inflation, with energy prices returning to putting 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.

During July, data from the British Office of 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. The increase was in line with economists' expectations, but exceeded the expectations of the Bank of England, which expected inflation to rise to 2.8 percent.

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.

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 stabilized at 2.6 percent in July, while services inflation fell to 3.4 percent from 3.6 percent.

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.

This time, the Bank of England is trying to avoid a repeat of the experience of 2022, when the energy shock caused by the Russian invasion of Ukraine pushed British inflation to more than 11 percent. Current circumstances differ in one key respect; The labor market is becoming weaker, which may limit companies' ability to pass on rising energy costs into wages and prices.