Third time: Nomura warns, this “Japanese bond storm” is different!

The storm in Japan’s government bond market has risen again, but this time its nature is completely different.

According to Wind Trading Desk, Nomura Securities strategist Naka Matsuzawa warned in the latest report that this third warning from bond vigilantes regarding Japan’s economic policy fundamentally differs from the previous two—the trigger comes from overseas, and the dominant force has shifted from the ultra-long end to the 10-year JGB yield, which better reflects market expectations of the neutral interest rate. This means this round of selling can no longer be simply labeled as panic selling.

The 10-year breakeven inflation rate (BEI) has risen to 2.15%. The sharp rise in inflation expectations is prompting market concerns about whether the Bank of Japan can keep inflation stable near its 2% target. Meanwhile, fading expectations for Fed rate cuts, intensifying political turmoil in the UK, and the US-Iran war pushing up oil prices—all overseas factors—are driving foreign investors out of Japan’s bond market, and these pressures cannot be resolved by domestic Japanese policy alone.

The yen continues to weaken against the dollar into the 158.0 to 158.5 range, and Japanese stocks are also facing downward pressure from instability in both the bond and forex markets. Matsuzawa pointed out that the boost to stock prices from reflation policy depends on the tolerance of bond and FX markets for such policies—as current bank stocks are declining against the backdrop of sharply rising yields, they have sent out a signal of “problematic rate hikes”.

Three warnings, upgraded nature

Since the Sanae Takaichi administration took office, bond vigilantes have issued three warnings regarding economic policy management:

The first occurred just after the government took office in October last year,

The second occurred in January this year when the food tax reduction proposal emerged,

The third is the current round of selling led by overseas factors.

The Nomura report points out there are two key differences from the previous two rounds:

First, the trigger comes from overseas—the US-Iran war driving up oil prices, Fed rate cut expectations evaporating, UK political risks worsening, and multiple factors combine to push foreign investors out of Japanese bonds;

Second, the dominant force in this round of selling is no longer the typically supply-demand sensitive ultra-long end, but the 10-year yield—which more directly reflects market estimates of the neutral rate.

Matsuzawa warns that, since Japan’s Ministry of Finance has recently deployed FX intervention tools, policy instruments available to stabilize the market are becoming limited, and it would be dangerous for the government to once again dismiss this round of turmoil as mere panic selling.

Fiscal anxieties continue to ferment

The direct trigger for this round of JGB selling is reports that the government is considering compiling a supplementary budget. Although the government has previously stated it will provide energy subsidies to cope with rising oil prices, the introduction of a supplementary budget seems only a matter of time. Yet Finance Minister Satsuki Katayama just denied the necessity of compiling a supplementary budget in the near term, which immediately caused investor sentiment to deteriorate sharply.

Meanwhile, discussions about food tax reductions are still progressing in parallel, fueling ongoing market concerns about additional JGB issuance. The Japan-US finance minister meeting failed to alleviate concerns about fiscal expansion or fears of the BOJ lagging behind the curve, ultimately triggering capitulation-style selling.

Inflation expectations jump, BOJ under increasing pressure

Nomura’s report specifically highlights that the 10-year BEI has risen to 2.15%, and the sharp uptick in inflation expectations has become an independent risk—the market is starting to question the BOJ’s ability to keep inflation stable at its 2% target.

This concern is directly pushing up market estimates of the neutral rate, placing upward pressure on 10-year yields.

Notably, the BOJ at last week’s policy meeting stayed put, citing the situation in the Middle East and refrained from raising rates, while the fiscal expansion pressure from energy subsidies continues to accumulate.

Matsuzawa pointed out that these Japan-specific factors make foreign investors cautious about increasing their holdings of JGBs.

Foreign capital cautious, Japanese investors turn overseas

According to Nomura’s reference to the latest weekly investor flow data for the week of May 4, foreign investors saw net buying of Japanese stocks and bonds that week, with net equity purchases exceeding 1 trillion yen, marking a second consecutive week of net buying. Since the preliminary ceasefire agreement between the US and Iran was reached in early April, foreign funds have generally been net buyers, with cumulative net buying since the outbreak of the war reaching 1.0 trillion yen.

However, foreign investors’ attitude toward JGBs is clearly more cautious, with cumulative net buying during the same period only 0.9 trillion yen. Matsuzawa analyzes that worries about fiscal expansion and the risk of the BOJ lagging behind the curve are the main reasons foreigners have been reluctant to increase their JGB holdings substantially.

Meanwhile, Japanese domestic investors have seen two consecutive weeks of large net buying of foreign bonds. Nomura notes that the trend of Japanese investors accelerating their reduction of overseas bond holdings since February seems to have ended, with market participants perhaps expecting that oil prices will drop after a ceasefire agreement, bringing expectations for Fed rate cuts back up.

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