2.3 trillion yuan fiscal stimulus meets interest rate hikes, Japanese bond market faces its most intense sell-off in thirty years.

Japan’s bond market is undergoing a dramatic revaluation triggered by the “internal tug-of-war” between fiscal expansion and monetary tightening. Long-term debt sustainability concerns are pushing benchmark borrowing costs to their highest levels in thirty years.

The 14-year, $2.3 trillion long-term spending plan proposed by the Sanae Takaichi government has become the core trigger for the sell-off in long-term government bonds. Meanwhile, the Bank of Japan raised its policy rate to 1% and announced it will stop reducing its bond purchases next year, stabilizing them at about 2 trillion yen per month.

The policy combination of fiscal stimulus and monetary normalization has directly led Japan’s 10-year government bond yield to rise to 2.85%, a new high since 1996. The surge in long-term yields not only increases the interest payment burden for Japan’s sovereign debt, which exceeds 200% of GDP, but also prompts global investors to reassess the pricing logic of Japanese assets.

Against a backdrop of continued yen weakness and rising inflation expectations, the policy divergence between the Bank of Japan’s anti-inflation stance and pro-growth efforts is making the long end of the Japanese government bond yield curve exceptionally fragile. The market is demanding higher term premiums for potential fiscal risks.

$2.3 Trillion Fiscal Plan Triggers Long-End Sell-off

The large-scale long-term spending plan introduced by the Sanae Takaichi government has broken previous market expectations about Japan’s fiscal discipline.

The 14-year, $2.3 trillion spending plan has directly triggered deep concerns among investors regarding the sustainability of Japan’s long-term debt. Currently, Japan’s sovereign debt has exceeded 200% of its GDP, making it the largest sovereign debt pile in the world.

This concern is quickly reflected in the pricing of long-term government bonds. The sell-off this year has pushed the 10-year Japanese government bond yield to 2.85%, while the 30-year yield has soared above 4%, hovering around the intraday all-time high of 4.2% set in May.

The repricing of long-term risks has significantly increased the term premium. Investors now require a premium of 1.4 percentage points for Japan’s 10-year borrowing versus the 2-year, up sharply from less than 1 percentage point in April.

In contrast, term premiums in other major bond markets such as the US and Germany have recently remained flat or trended down, highlighting the unique selling pressure facing Japan’s bond market.

Central Bank Rate Hikes and Bond Purchase Adjustment Intensify Policy Contradictions

While fiscal policy expands aggressively, the Bank of Japan’s monetary operations present a complex policy contradiction.

Last month, the Bank of Japan raised its policy rate to 1%, seeking to pursue monetary policy normalization. However, the bank also announced that next year it will stop reducing its monthly bond purchases, stabilizing them at about 2 trillion yen. The market interprets this as a cautious stance toward further tightening.

Alex Everett, Investment Director at Aberdeen Investments, pointed out that the Bank of Japan’s caution on further rate hikes, continued yen weakness, and concerns about fiscal policy have rendered the long end of the Japanese government bond yield curve particularly fragile.

Investors fear that this “fiscal accelerator, monetary brake” combination may cause the Bank of Japan to fall behind the curve in its fight against inflation. The market broadly worries that if the central bank acts too slowly, inflation may break above and stay above the 2% target for a prolonged period.

As Chief Investment Officer Stephen Jones noted, the current script reflects how Japan built the world’s largest debt pile based on the assumption that “funds would always be free,” but as monetary policy tightens, this fundamental logic is undergoing a profound change.

Foreign Exchange Intervention and Bond Market Volatility: Macro Resonance

Japan’s severe bond market volatility is not an isolated event but is intertwined with the depreciation of the yen and forex interventions, forming a complex macro resonance.

Recently, the USD/JPY exchange rate broke through the 161 level, hitting a new two-year low. To curb excessive depreciation of the yen, the Ministry of Finance has spent over 10 trillion yen intervening in the FX market since late April, with officials frequently issuing intervention warnings.

However, massive forex intervention has failed to fundamentally reverse the yen’s weakness. The sharp sell-off in Japanese government bonds, driving yields higher, has not effectively attracted capital inflows to support the yen. Instead, it has intensified concerns over Japan’s fiscal health and further suppressed the yen.

The US-Japan interest rate differential and the policy divergence within the Bank of Japan between fighting inflation and supporting growth continue to be the key macro factors weighing on the yen and driving bond market volatility.

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