Japan's government bond market continues to face pressure as the country prepares to issue new government bonds worth approximately 29.6 trillion yen ($189.55 billion) for the fiscal 2026 budget, according to a draft reviewed by Reuters. The planned issuance, part of a record-size budget totaling around 122.3 trillion yen, has intensified investor concerns about fiscal sustainability and driven bond yields to new highs.

Record Budget and Debt Issuance Plans

The annual budget, set to be finalized on Friday, represents Prime Minister Sanae Takaichi's first comprehensive fiscal plan since taking office in October. Key budget parameters highlight the scale of Japan's fiscal expansion:

Despite record tax revenues, the projected income falls short of covering rising social welfare, defense, and debt-servicing costs, necessitating increased borrowing. The massive spending comes on top of a 21.3 trillion yen stimulus package compiled in November, focused on cushioning households from rising living costs.

Bond Yields Surge to Record Levels

Concerns about debt oversupply have triggered significant volatility in Japan's government bond market. The latest yield movements reflect growing investor anxiety about the country's fiscal trajectory:

The 30-year yield's climb to 3.45% on Wednesday marked another record, continuing the upward trajectory that began in early November. The 10-year yield has recently breached the 2% level for the first time in 26 years, signaling a fundamental shift in Japan's interest rate environment.

Policy Stance and Market Response

Prime Minister Takaichi has made "proactive" spending a flagship of her economic policy, emphasizing the need to revitalize Japan's economy. However, her administration has moderated its fiscal rhetoric as bond yields have risen. In a recent Nikkei interview, Takaichi sought to reassure markets, stating the government would not resort to "irresponsible" debt issuance or tax cuts.

Noriatsu Tanji, chief bond strategist at Mizuho Securities, observed the evolving market dynamics: "Since the Bank of Japan's December policy meeting, the move to entrench 10-year yields in the 2% range appears to be accelerating." This shift reflects both fiscal concerns and the central bank's signals regarding continued interest rate increases.

Fiscal Sustainability Concerns

The substantial increase in government borrowing has raised questions about Japan's long-term fiscal health. While Takaichi acknowledged that Japan's debt-to-GDP ratio remains high despite improving trends, the market continues to scrutinize the sustainability of the country's expansionary fiscal approach. The combination of record spending, increased bond issuance, and rising yields presents a challenging environment for policymakers balancing economic growth objectives with fiscal responsibility.

Japan's government bond market witnessed significant movements on Tuesday, particularly in the super-long-dated securities sector. Investors engaged in strategic selling to steepen the yield curve ahead of scheduled government auctions later this month. This activity has led to notable increases in yields across various maturities.

Yield Movements

Market Dynamics

The yield spread between 10-year and 30-year bonds had narrowed considerably last week, reaching its lowest point since May at 138 basis points on October 30. This was a significant contraction from the record spread of 170 basis points observed in early September.

Investor Strategy

Market participants are adopting a tactical approach by selling longer-dated bonds. This strategy aims to secure more favorable pricing at the upcoming auctions for 20-year, 30-year, and 40-year bonds.

Improved Demand Factors

Two key factors have contributed to the improved demand for super-long bonds:

1. Reduced Auction Volumes: The finance ministry's decision to decrease auction volumes earlier this year has helped in controlling rising yields.

2. Stock Market Rally: The recent rally in Japanese stocks has supported demand as pension funds rebalance their portfolios.

Implications

These market movements reflect the intricate balance between investor positioning and government policy. As Japan navigates its monetary policy, these yield fluctuations could have broader implications for the global bond market and currency exchange rates.

Investors and market watchers should keep a close eye on the upcoming auctions, as they may provide further insights into the long-term trajectory of Japan's bond market and its impact on the wider economic landscape.