Japan 10-Year Bond Yields Hit 1%, BOJ May Tighten Policy

Key Takeaway

• Japan's 10-year bond yields climbed above 1%, driven by speculation of BOJ tightening and potential rate hikes in July.
• The BOJ may reduce JGB purchases, with June 14 as a key date for potential policy shifts, adding to market volatility.
• Persistent yen weakness and rising producer prices are pressuring the BOJ to lift rates, impacting global bond markets.

Rising Japan Bond Yields

Japan's 10-year bond yields have been on an upward trajectory, climbing back above 1% on Monday. This movement is driven by speculation that the Bank of Japan (BOJ) will soon tighten its monetary policy. The yield is now just six basis points below the 12-year high set last month, a level it reached as recently as the last week of May. Bloomberg Economics suggests that Governor Kazuo Ueda may use the upcoming BOJ meeting to prepare investors for a potential rate increase in July. Additionally, the BOJ is expected to start quantitative tightening by reducing its Japanese Government Bond (JGB) purchases.

Mark Cranfield, an MLIV blogger, notes that the BOJ could surprise the market with a hawkish stance due to the persistent weakness of the yen. "The timing is opportune for aggressive traders ahead of this week’s Bank of Japan meeting which could spring a hawkish surprise given persistent yen weakness," Cranfield writes. Japan's producer prices, expected to rise both month-over-month and year-over-year on Wednesday, add to the anticipation of higher yields. Benchmark Treasuries are also contributing to the global yield increase, with MLIV strategist Alyce Andres warning that bond investors may face challenges ahead due to stubborn inflation.

BOJ's Potential Policy Shifts

Investors are bracing for increased volatility in Japan's sovereign bond market as the BOJ considers reducing its massive debt holdings. Last month, the BOJ purchased only ¥4.5 trillion ($29 billion) of government bonds, the lowest amount since March 2013. A majority of BOJ watchers forecast that the central bank will decide on June 14 to cut the amount of sovereign notes it buys. People familiar with the matter have indicated that such a shift is under consideration.

The 10-year yields have experienced significant fluctuations, reaching as high as 1.1% last month, a level unseen since 2011, before giving up about half of the gain. The spread between overnight-indexed swaps used for hedging and 10-year notes has narrowed to the least since 2022, reflecting concerns about reduced BOJ debt buying. Implied volatility on debt futures has climbed above this year’s average. "With the current volatile market, the BOJ is unlikely to give a strong forward guidance so that they can keep policy flexibility," said Shoki Omori, chief desk strategist at Mizuho Securities Co. in Tokyo. "Investors will continue to expect further bond-buying cuts in the future, putting upward pressure on yields."

Market Dynamics and Investor Sentiment

The BOJ has accumulated more than half of the nation’s government debt, primarily due to its two decades of quantitative easing. The persistent weakness in the yen is adding pressure on the central bank to lift interest rates, a move that would likely support the Japanese currency. However, many analysts are revising their forecasts for when the BOJ will hike rates, pushing expectations further into the future. This comes at a time when the European Central Bank has cut rates, and other central banks are considering similar actions.

Japan's radical easy-money experiment has weakened many mechanisms that help investors price and trade bonds. Despite this, the main gauge for the market’s functioning has been improving since May 2023 as the BOJ dismantled its yield-curve-control and negative-interest-rate policy. This has spurred investor speculation that the central bank will seek to further cut bond buying to help shore up the health of the nation’s debt market. Swings in debt prices are becoming more severe as the BOJ weighs further policy changes, highlighted by the 4.06% implied volatility for 10-year bond futures on Friday, higher than this year’s average of 3.60%.

Street Views

• Bloomberg Economics (Bullish on Japan's bond market tightening):

  "Governor Kazuo Ueda will probably use the session to prepare investors for a rate increase in July. The BOJ will also probably start quantitative tightening by announcing a reduction in its JGB purchases."

• Mark Cranfield, MLIV (Hawkish on BOJ policy shift):

  "The BOJ could spring a hawkish surprise given persistent yen weakness."

• Alyce Andres, MLIV (Bearish on global bond markets):

  "Bond investors are headed for pain in the weeks ahead amid growing signs that inflation is refusing to abate."