Japanese government bond yields continued their upward trajectory on Tuesday, with the 10-year yield rising after a moderately firm bond auction outcome. Markets are now pricing the Bank of Japan's terminal rate at approximately 1.70%, reflecting growing concerns about inflation and the central bank's policy response.

Latest Bond Yield Movements

Japanese government bonds showed mixed performance across the yield curve following Tuesday's auction results:

The 10-year JGB yield reversed course to inch higher at 2.12%, after initially falling 1 basis point to 2.105% ahead of the auction. This movement came despite the bond auction showing moderately firm demand.

Bond Auction Analysis and Market Sentiment

Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management, noted that despite current high yield levels, the auction outcome was not particularly strong. "That is because the market is concerned that the Bank of Japan is behind the curve in dealing with the risk of inflation and it will have to raise the rate higher," he explained.

The auction results reflect broader market anxiety about the BOJ's policy trajectory. Investors remain concerned that the central bank may need to implement more aggressive rate increases than previously anticipated to combat inflationary pressures.

Market Expectations for BOJ Policy

Markets have significantly revised their expectations for the Bank of Japan's terminal rate. According to forward one-year overnight index swaps two years ahead, markets now expect the BOJ's terminal rate to rise to approximately 1.70%, with OIS pricing in roughly 1.6956%.

The overnight index swap, which involves swapping the overnight call rate for a fixed interest rate, provides an effective gauge for monitoring market perceptions about BOJ monetary policy direction.

Currency Pressures and Inflation Dynamics

The yen's continued weakness against major currencies remains a critical factor driving market expectations for further BOJ action. The central bank raised its policy rate to 0.75% from 0.50% last month, but the yen has struggled to regain ground as markets expect the pace of rate hikes to remain measured.

A weaker yen increases import costs across the economy, fueling inflation and reinforcing expectations for additional interest rate increases. This currency-inflation dynamic continues to challenge the BOJ's gradual approach to monetary policy normalization.

Government Bond Issuance Strategy

In response to current market conditions, the government has decided to reduce new issuance of super-long government bonds for the next fiscal year while maintaining current levels of benchmark 10-year JGB issuance. These measures aim to address oversupply concerns and help stabilize market conditions amid the challenging yield environment.

Tokyo's consumer price inflation eased more than expected in December, providing relief as pressure from food and energy costs diminished compared to previous months. The Japanese capital saw its consumer prices excluding fresh food rise 2.3% in December from a year earlier, according to the Ministry of Internal Affairs and Communications.

Inflation Data Shows Significant Cooling

The December inflation reading represents a sharp deceleration from the previous month's 2.8% rate, marking the first time since August that Tokyo has experienced a slowdown in these key figures. The decline exceeded economist expectations, who had forecast the reading to slow to 2.5%.

Food and Energy Drive Decline

The inflation slowdown was largely driven by softer food price gains and falls in energy costs. A deeper measure that excludes energy fell to 2.6%, while the total inflation gauge decreased to 2.0% from 2.7% in the prior period. Tokyo's statistics serve as a leading predictor of inflation patterns across Japan, with the Tokyo Metropolitan Region having an estimated population of around 40 million.

Bank of Japan Maintains Hawkish Stance

Despite the cooling inflation data, the development is unlikely to deter the Bank of Japan from further rate hikes. The Japanese central bank recently voted unanimously to lift the policy rate to 0.75%, continuing its trend of raising interest rates while other major economies cut benchmark rates. This recent hike has taken the benchmark rate to the highest level since 1995.

Bank of Japan Governor Kazuo Ueda hinted at further monetary tightening during the rate announcement, noting that despite cooling inflation, the consumer price index for the capital city remains above the central bank's target of 2%.

Market Response

Japanese equity markets responded positively to the inflation news, with the Nikkei 225 index trading with gains of 0.94% or 475.86 points, reaching 50,883.65 at the time of reporting. The positive market reaction suggests investors view the inflation moderation as a balanced development that maintains economic stability while supporting the central bank's policy framework.