Japan's bond rout threatens Takaichi's fiscal strategy as 10-year yield nears 3%

Japan is running low on options to fight a bond rout that could push debt financing costs above government estimates and leave Prime Minister Sanae Takaichi’s ambitious spending agenda hostage to forces she cannot control, analysts say.

The global bond selloff has found its epicentre in Japan, with the benchmark 10-year yield touching a three-decade high of 2.945% on Tuesday before easing to around 2.89% on Wednesday. Investors are increasingly nervous about Japan’s towering debt pile and inflation risks stemming from the Middle East war.

A sustained move above 3% — the very level the government used as its budget assumption — would send debt-financing costs surging past the 31 trillion yen ($195 billion) currently set aside for the current fiscal year. Under the finance ministry’s baseline estimate assuming the 10-year yield will climb to 3.6% in fiscal 2029, debt-servicing costs would rise to 41 trillion yen that year.

Higher yields would also threaten the affordability of Takaichi’s flagship growth initiatives. Conservatives within the ruling party are pressing her to curb spending, making the fiscal balancing act more difficult.

**Inflation pressures complicate BOJ stance**

Although government subsidies have kept core inflation below the Bank of Japan’s 2% target, the central bank has warned of the risk of an inflation overshoot that could warrant an early rate hike. The prospect of sooner and faster rate hikes has fuelled a repricing across bond markets, with investors now seeing a realistic path toward rates reaching 2%, well above earlier expectations for a peak near 1.5%, analysts say.

“Japan hasn’t experienced such sticky price pressures since the previous oil shock,” said Mari Iwashita, executive rates strategist at Nomura Securities. “The challenge of anchoring inflation at the BOJ’s 2% target is becoming bigger.”

The government expects real GDP growth of 0.9% in the current fiscal year ending March 2027, followed by 1.1% the next year. Takaichi’s case for increased spending rests on the assumption that economic growth will outpace long-term borrowing costs, allowing Japan to sustain its enormous debt burden without jeopardising fiscal stability.

That premise would come under doubt if the 10-year yield exceeds 3% with inflation running at 2% and real growth hovering around 1% at best.

**Limited policy tools available**

As bond jitters persist, markets are increasingly focused on whether policymakers have credible options to contain the selloff. Analysts say the tools available — sporadic cuts to bond issuance or emergency central bank buying — amount to little more than temporary patches for a bond market being squeezed by stubborn inflation and an increasingly loose fiscal stance.

The finance ministry could make ad hoc cuts to bond issuance or heed investor concerns about oversupply in a regular meeting scheduled for next month. “An adjustment to bond issuance at an irregular timing could help curb yield rises,” said Ataru Okumura, chief rates strategist at SMBC Nikko Securities.

Another option is for the Bank of Japan to ramp up bond-buying in emergency market operations, a tool it has kept in reserve even while tapering purchases. The tool is meant for sharp, disorderly yield spikes that threaten financial stability. While the BOJ won’t rule out the step entirely, it likely sees little need to intervene now since recent yield rises are driven by fundamentals, according to a source familiar with its thinking.

**Fiscal stance at odds with inflation fight**

Many analysts argue yields will remain under upward pressure unless the government rethinks its reliance on subsidies and tax cuts to ease cost-of-living pain — an expansionary approach that fuels demand and inflation.

“The BOJ can’t anchor inflation expectations if the government is ramping up fiscal spending and adding to price pressures from the Middle East war,” said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.

“Inflation has now become the key risk for anyone trading JGBs,” she said. “At the heart of the problem are market doubts over the government’s resolve to combat inflation.”

Making matters tougher, the government has ruled out spending caps on requests for strategic growth sectors in next year’s budget, a move that could force more debt issuance on top of revenue already lost to a planned food levy cut.

The surge in yields is emerging as a critical test for Takaichi’s economic strategy, with the bond market’s glare exposing the tension between Japan’s expansionary fiscal policy and the central bank’s push to normalise monetary policy. The outcome carries implications for global bond markets, as Japan remains the world’s largest creditor nation and its bond yields influence funding costs across Asia.