Weakened auction demand pushes Japan's 2-year government bond yield to a new high since 2008.

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Due to market expectations that the Bank of Japan will raise interest rates as early as October, demand at the auction for 2-year Japanese government bonds has hit its lowest level since 2009. The bid-to-cover ratio, a key indicator of demand, fell to 2.81 from the last auction, far below the 12-month average of 3.79.

On September 30, 2-year Japanese government bonds continued their downward trend, with yields rising by 1 basis point to 0.945%, the highest level since 2008.

Miki Den, senior rates strategist at SMBC Nikko Securities, said:

"Due to heightened expectations of a Bank of Japan rate hike in October, and investors' caution toward the end of the quarter, the auction result was weak."

Bloomberg strategist Mark Cranfield believes that today's poor performance in the 2-year Japanese government bond auction once again indicates that traders expect a rate hike by the Bank of Japan in October and are seeking higher yields to compensate for risk. The 2-year government bond yield may need to rise further to above 1% in order to stabilize the short end of the yield curve.

The market is closely watching the ruling Liberal Democratic Party’s presidential election on October 4 to assess its impact on expectations for the Bank of Japan's next rate hike. Overnight index swaps indicate a 67% probability of a rate hike.

Central Bank Policy Signals Strengthen Rate Hike Expectations

At its last meeting, two members of the Bank of Japan voted against keeping rates unchanged, fueling speculation in the market that the central bank is nearing a rate hike. Bank of Japan board member Asahi Noguchi said in a speech on Monday that the necessity to adjust policy rates is increasing.

In the minutes of this month's meeting, the central bank left ample room for a near-term rate hike, but did not explicitly suggest a hike in October.

Political Factors Add to Monetary Policy Uncertainty

Last week, leading Liberal Democratic Party presidential candidate Sanae Takaichi sought to distance herself from dovish remarks made a year ago, stating that the Bank of Japan should decide on the details of monetary policy independently. Another candidate, Shinjiro Koizumi, is seen as fiscally more cautious and supports letting the central bank move forward with monetary policy normalization. These statements have heightened market uncertainty about the direction of policy.

The market is watching speeches by the Bank of Japan governor and deputy governor, as well as the Tankan survey data this week, for more clues on the path of monetary policy. There will be a 10-year government bond auction on Thursday.

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