Japan's 2-year government bond auction is weak, with the market expecting inflation may force the central bank to "raise rates more aggressively."

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Due to rising inflation expectations and intensified pressure from the depreciation of the yen, the market expects that the Bank of Japan may be forced to raise rates more aggressively, resulting in weak demand at the Japanese 2-year government bond auction held on December 25.

On December 25, according to Bloomberg, the bid-to-cover ratio, a key indicator of demand, was only 3.26, lower than the previous 3.53 and the 12-month average of 3.65. After the auction results were announced, the yield on 2-year government bonds immediately rose by 2.5 basis points to 1.125%, the highest level since 1996.

This auction came less than a week after the Bank of Japan raised policy rates to a 30-year high. The weak auction result further highlights the market's unease about the Bank of Japan's policy stance. The 10-year breakeven inflation rate has risen this week to its highest level since data became available in 2004, reinforcing widespread concerns that the central bank’s actions are lagging behind the inflation curve.

Rate hike expectations push up short-term yields

The yield on 2-year government bonds is more sensitive to monetary policy expectations, and overnight index swaps show the market considers it possible that the central bank will raise rates again before September next year.

Katsutoshi Inadome, Senior Strategist at Sumitomo Mitsui Trust Asset Management, said:

"The market still worries that the Bank of Japan is falling behind the curve. This will likely prompt investors to avoid 2-year bonds, as these are most susceptible to such risks."

Although the momentum of the yen’s depreciation and rising yields was somewhat alleviated this week following verbal warnings from Japanese authorities on the exchange rate, the auction result is still regarded as a key indicator of market views on the central bank’s policy stance. Previously, Finance Minister Satuki Katayama warned that Japan has "discretion" to take bold action against exchange rate volatility that does not match fundamentals.

Increased bond issuance plan raises supply concerns

Investors are also watching government bond issuance plans related to the fiscal 2026 budget, which is expected to receive cabinet approval on Friday. According to Bloomberg, main dealers in Japan said this month they hope to increase issuance of 2-year, 5-year, and 10-year government bonds in the coming fiscal year, while calling for a reduction in sales of super-long-term bonds.

According to Reuters, citing two unnamed government officials, Japan may reduce new issuance of super-long-term government bonds next fiscal year to about 17 trillion yen ($109 billion), the lowest level in 17 years.

Miki Den, Senior Rates Strategist at SMBC Nikko Securities, pointed out:

"Now is not a good time to buy. The issuance of 2-year bonds is very likely to increase, so the risk of an immediate unrealized loss after purchase is high."

Inflation expectations hit record highs

The market's expectations for future price pressures continue to rise, with the 10-year breakeven inflation rate, a key indicator, surging this week to the highest level since data began in 2004. As a result, investors generally believe that the Bank of Japan may need to take more aggressive and larger interest rate hikes than expected in the future.

Bloomberg strategist Mark Cranfield said that for the Bank of Japan, rate hikes are a long and winding process. However, last week the Bank of Japan governor hinted that when the central bank seeks to persuade politicians that another rate hike is justified next year, they will have to start from scratch. Because of this, traders are now only expecting another 25 basis point hike in September 2026.

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