Japan’s Yield Curve Strains Under Fiscal and Monetary Policy Pressures

Japan’s bond market is showing signs of structural fragility as fiscal stimulus clashes with inflationary pressures and shifting demand dynamics. The 40-year Japanese government bond (JGB) yield has surged over 100 basis points this year to 3.745%, while 30-year yields have risen by more than a percentage point to 3.37% . This divergence contrasts with the 55-basis-point increase in five-year JGB yields to 1.315%, highlighting a pronounced steepening in the yield curve’s long end . The Bank of Japan (BOJ) faces mounting scrutiny for its delayed response to inflation, which has exceeded its 2% target for years .

The fiscal backdrop has worsened with the announcement of a ¥17.7 trillion supplementary budget—surpassing the ¥13.9 trillion plan from former Prime Minister Shigeru Ishiba. This expansion, framed as support for households and domestic economic resilience, risks amplifying inflationary pressures amid existing debt concerns . Derek Halpenny of MUFG warned that markets tolerate budgets comparable to last year’s ¥13.9 trillion, but deviations could trigger volatility . Investors are interpreting the larger-than-expected spending as evidence of Tokyo’s reluctance to curb deficit growth .

Market participants are hedging against policy missteps. Mark Dowding, chief investment officer at BlueBay Asset Management, has shorted Japanese debt, particularly in the 10-year sector, anticipating further curve steepening if policy errors persist . James Athey of Marlborough Investment Management, who holds bearish positions in five- to 10-year JGBs, criticized the inflation-fighting strategy of expanding budget deficits as “questionable to say the least” . The 20- to 40-year bond segment faces heightened vulnerability due to declining demand from life insurance companies, which historically provided liquidity but are now “no longer active buyers” . Halpenny noted that banks also avoid purchasing long-dated bonds, leaving the sector exposed to fiscal shocks .

The BOJ’s credibility is further eroded by its perceived lag in tightening policy. Thomas Reich of Citigroup Inc. anticipates continued pressure on Japanese bonds as market expectations for rate hikes and fiscal discipline remain unmet . This dynamic creates a feedback loop: delayed monetary tightening fuels inflation, which in turn justifies larger fiscal interventions, exacerbating debt concerns and bond market instability .

The implications extend beyond Japan’s borders. As a key developed market and a major issuer of long-dated debt, Tokyo’s fiscal and monetary misalignment could influence global yield curves and capital flows. The shift in demand from life insurance companies reflects broader structural changes in institutional investor behavior, with potential ripple effects in other bond markets .