Japan Government Bond 5Y

Japan's 2-year bond yield is closing in on the 2% mark, a level it has not reached in more than 30 years. The market is increasingly of the view that Japan's long battle with deflation is over and that the Bank of Japan needs to raise its policy rate to a restrictive level. The 2-year yield has doubled over the past 12 months and is now more than six times its level at the same time in 2024. The 5-year yield hit a record 2.43% on the 28th, and the 2-year, 1-month interest rate swap rate also rose to a record 2.5%. According to Tokyo Tanshi, the probability of a rate hike to a 1.5% policy rate in October, based on swap rates, is 36%, while a December hike is priced in as nearly certain. The timing of the next rate hike may depend on the results of the Bank of Japan's Tankan survey due on the 1st, and Takashi Fujiwara of Resona Asset Management noted that if capital investment in the Tankan proves solid, the view that a rate hike could come as early as October may gain strength.

The 2-year yield, which is sensitive to monetary policy expectations, rose as high as 1.975% on the 28th, up 4 basis points from the previous trading day, approaching a level that would mark the first 2% reading in 31 years. Selling pressure hit other maturities as well, with the 5-year yield climbing 3 basis points to 2.43%, a record high. After the Bank of Japan decided on a rate hike at this month's policy meeting, in line with market expectations, Governor Kazuo Ueda gave no clear signal on the pace of future tightening, and concern is spreading in the market that the BOJ is falling behind the curve. SMBC Nikko Securities chief rates strategist Jin Okumura said trades betting on an acceleration of BOJ rate hikes are gaining the upper hand, while former BOJ board member Kazuo Momma said in an interview with Bloomberg that there is a 20% to 30% chance the central bank raises its policy rate for a second straight meeting in October. In the overnight index swap market, the probability of an October hike stands at about 40%, with an additional increase by December fully priced in.

In the Tokyo yen bond market on the 1st, the yield on the new 10-year government bond, a key indicator of long-term interest rates, briefly reached 3.00%, the highest level in 30 years since September 1996. Concerns over inflation and fiscal deterioration have led to views that reaching 3% is merely a waypoint. Expectations of further rate hikes by the Bank of Japan and wariness over the aggressive fiscal policy of the Takaichi administration have prevented the dissipation of expectations for higher rates, and the day's 10-year bond auction was also seen as weak. The yield on the new 2-year bond rose to 1.795%, the highest since 1995, and the yield on the new 5-year bond briefly hit a record high of 2.265%. In the market, there is a strong view that inflation concerns will persist toward year-end due to wariness over fiscal policy, higher energy prices from heightened tensions in the Middle East, and a weaker yen. Daisuke Uno of Sumitomo Mitsui Banking Corporation said, "Until the Takaichi administration retracts its aggressive fiscal policy, upward pressure on interest rates will continue," and Eiji Doke of SBI Securities predicts that the range for long-term rates could "reasonably rise to 3-3.25%."

Foreign investors sold a net 1.28 trillion yen of two-year and five-year Japanese government bonds in July, the largest net selling since 2006, as the yen kept weakening and fueled expectations that the Bank of Japan may accelerate interest rate hikes. Data from the Japan Securities Dealers Association showed that foreign investors remained net buyers of long-term bonds with maturities over 10 years, worth 889.8 billion yen in the same month, indicating that selling was concentrated in short- to medium-term bonds, which are more sensitive to the interest rate outlook. The selling came as the yen hit its weakest level in nearly 40 years, prompting joint market intervention by Japan and the United States, while Bank of Japan Governor Kazuo Ueda signaled that policy could be adjusted at the September meeting.