In the global bond market storm, "high-market economics" has become the latest vulnerability: Japan's countermeasures are limited.

Japan's means to cope with the bond market crash are dwindling, and this downturn may elevate debt financing costs beyond the government's expectations, placing Prime Minister Kishi Sanaes ambitious spending plans at the mercy of uncontrollable factors. Analysts state that the currently available tools to stabilize the marketincremental reductions in bond issuance or emergency purchases by the central bankare merely temporary remedies for a bond market pressured by stubborn inflation and increasingly lax fiscal policy. Mari Iwashita, an executive interest rate strategist at Nomura Securities, mentioned: Since the last oil crisis, Japan has never experienced such stubborn price pressures. The challenge of anchoring the inflation rate to the Bank of Japans 2% target is becoming increasingly daunting. At the center of the global bond sell-off is Japan, where the benchmark 10-year government bond yield is set to break the 3% mark for the first time since the mid-1990s. Investors are becoming increasingly concerned about Japan's massive debt and the inflation risks brought on by the conflict in the Middle East. On Tuesday, the yield on Japans 10-year government bonds reached a thirty-year high of 2.945% before sliding to around 2.89% on Wednesday. Although government subsidies have kept the core inflation rate below the 2% target, the Bank of Japan has warned of the risk of inflation overshooting, which may necessitate an early interest rate hike. Expectations of a faster and earlier rate increase have alleviated concerns about the Bank of Japan's lagging response to inflation. However, analysts say this has also led to a repricing in the bond market, with investors now seeing a greater likelihood of rates reaching 2%, much higher than the previously expected peak of nearly 1.5%. Severe Test The surge in yields poses a severe test to Kishi Sanae's economic strategy. She argues that the rationale for increased spending is that economic growth will outstrip long-term borrowing costs, allowing Japan to maintain its substantial debt burden without jeopardizing fiscal stability. If the 10-year Japanese government bond yield exceeds 3% and inflation remains at 2%, the real growth rate may only linger around 1%, casting doubt on this premise. The Japanese government estimated in July that the actual GDP growth rate for the current fiscal year, ending in March 2027, will be 0.9%, rising to 1.1% in the next fiscal year. Higher yields would also threaten the affordability of Kishi Sanae's key economic growth plans. Meanwhile, conservative voices within the ruling party are urging her to cut spending. If interest rates remain above 3% (the level the government has assumed in budgeting), the cost of debt financing will skyrocket beyond the currently reserved 310 trillion yen (approximately 195 billion USD), weakening Kishi Sanae's initiatives to inject investment into growth-oriented sectors. According to the department's benchmark estimates, if the yield on Japan's 10-year bonds rises to 3.6% by fiscal 2029, the debt servicing costs for that year would increase to 410 trillion yen. Worse still, the government has ruled out setting a cap on expenditure requests for strategic growth areas in next years budget, a move that may force the government to issue more debt in the wake of revenue losses from planned cuts to food taxes. Key to Japan's Government Response As the bond market remains turbulent, attention is increasingly on whether policymakers have credible options to stem the sell-off. Analysts suggest that the Treasury may temporarily reduce bond issuance or address concerns about oversupply of bonds in routine meetings with investors next month. Ataru Okumura, chief interest rate strategist at SMBC Nikko Securities, stated, Adjusting the timing of bond issuance to make it irregular can help suppress rising yields. Furthermore, any indications that the ministry may consider cutting the issuance of 10-year bonds are also worth noting. Another option is for the Bank of Japan to increase the scale of its emergency market operations to purchase bonds. Even while gradually reducing purchase volume, the Bank of Japan has kept this tool available to respond to sharp, disorderly spikes in yields that threaten financial stability. A source familiar with the Bank of Japan's thinking noted that while the Bank will not completely rule out the possibility of intervention, given that the recent rise in yields is driven by fundamental factors, it may determine that now is not the time to step in. Many analysts believe that unless the government reconsiders its reliance on subsidies and tax cuts to alleviate cost-of-living pressures, yields will continue to face upward pressure, as such expansionary measures only stimulate demand and inflation. Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, remarked: If the government increases fiscal spending and exacerbates the price pressures stemming from the conflict in the Middle East, the Bank of Japan will be unable to stabilize inflation expectations. Inflation has now become the primary risk facing everyone involved in trading Japanese government bonds. The crux of the issue lies in the markets doubts about the government's determination to curb inflation.