Japan's long-term interest rates have surged to their highest level in nearly 30 years. Amid ongoing inflation and a weak yen, concerns are growing that the government's stimulus measures may delay further interest rate hikes by the Bank of Japan, leading to increased selling pressure on government bonds. The market has begun to sound alarms regarding the active fiscal policy of the administration led by Sanae Takaichi.
On July 3, the yield on Japan's benchmark 10-year government bonds briefly rose to 2.810%, the highest level since October 1996. However, by 3 p.m., the yield had dropped to 2.770%, down 0.025 percentage points from the previous day, as buying interest emerged at the elevated rates. An increase in bond yields typically indicates a decline in bond prices.
This rise in interest rates is largely influenced by domestic factors. In May, Japan's long-term interest rates also climbed to 2.8% due to geopolitical tensions in the Middle East, rising oil prices, and increases in interest rates in the U.S. and Europe. However, this time, while U.S. and European rates remain relatively stable, Japan's rates are experiencing a notable upward trend. The Nihon Keizai Shimbun (Nikkei) noted that concerns about delayed fiscal and monetary policy responses in Japan have intensified selling in the bond market.
The immediate trigger for the rise in yields was instability in government bond supply. Following a poorly received auction of 10-year bonds by the Ministry of Finance on July 2, which showed weak investor demand, selling pressure quickly shifted to the newly issued 10-year bonds starting July 3. However, the market's primary concern appears to be the potential delay in the Bank of Japan's response to inflation. Last month, the Bank raised its benchmark interest rate to 1.0%, indicating that the core inflation rate could exceed its 2% target. A recent nationwide corporate short-term economic survey also revealed that companies' inflation expectations for one, three, and five years ahead have all increased compared to previous surveys, with the three- and five-year forecasts reaching their highest levels since the survey began in 2014.
In this context, the Takaichi administration's cautious messaging regarding further interest rate hikes has heightened market anxiety. The draft of the government's "Basic Policy on Economic and Fiscal Management and Reform," finalized on June 30, includes language urging the Bank of Japan to implement appropriate monetary policy based on economic, price, and financial conditions. The market interprets this as a signal that the government may seek to restrain the Bank's rate hikes.
Concerns about fiscal deterioration are also mounting. The Takaichi administration has proposed a growth strategy that aims for over 370 trillion yen (approximately $3.5 trillion) in investments from both the government and private sectors by 2040 across 17 strategic areas. Additional government spending is reportedly planned at around 10 trillion yen annually. Furthermore, the absence of the term "fiscal consolidation" from the draft policy raises fears that fiscal discipline may weaken.
These concerns are reflected in the yield curve. The yield on the two-year bonds, which are heavily influenced by policy rates, has already incorporated much of the Bank of Japan's anticipated rate path, limiting further increases. In contrast, the yield on 10-year bonds, which reflect inflation and fiscal risks, is rising rapidly. The spread between the two-year and 10-year bond yields widened to 1.378 percentage points on the morning of July 3, the largest since the Bank of Japan began normalizing its monetary policy in 2024. The Nikkei reported that market apprehension regarding the Bank's delayed response to rising prices is pushing long-term interest rates higher.
The government is aware of these market concerns and is attempting to mitigate them. Finance Minister Minoru Kiwuchi stated in an interview with the Nikkei on July 2 that the rise in interest rates cannot be solely attributed to "responsible active fiscal policy," noting that various factors, including growth and inflation expectations and risk premiums, are at play. He emphasized that the Takaichi administration's investment plans are "not excessive" and that they will ensure fiscal sustainability while making necessary expenditures.
In contrast, the opposition has launched a critique. Junya Ogawa, leader of the Center-Right Reform Union, criticized the Takaichi administration's "responsible active fiscal policy" during a press conference on July 3, arguing that the rise in long-term interest rates signals a warning from the market. He expressed concern that "a yellow light is flashing across the economy, finance, and monetary policy, and it may soon turn red," calling for a fundamental reassessment of the active fiscal policy approach.
As the yen continues to weaken and inflationary pressures persist, the market is closely monitoring the Takaichi administration's fiscal strategy alongside the pace of potential interest rate hikes by the Bank of Japan. How effectively the government balances fiscal expansion with fiscal discipline will be a key factor influencing the trajectory of long-term interest rates.
* This article has been translated by AI.
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