Yen Weakens as Japan's Revised GDP Sparks Stimulus Push and Bond Yields Rise

Japan's economy shrank more than initially reported in the third quarter, according to a revised government assessment, deepening the case for a large stimulus package announced by Prime Minister Sanae Takaichi. Gross domestic product fell at an annualized rate of 2.3%, surpassing the initial estimate of a 1.8% decline. This marks the first contraction in six quarters, raising concerns about the nation's economic resilience.

The downward revision was driven by weaker-than-expected business spending and housing investment. The slowdown comes amid a backdrop of inflationary pressures and a struggling labor market, with real wages falling for the 10th consecutive month. The updated figures have intensified pressure on the government to support households and businesses.

Takaichi's stimulus package, unveiled in response to the economic decline, includes ¥17.7 trillion ($114 billion) in new spending. The measures aim to ease the burden of inflation on households through utility subsidies, tax cuts, and wage support for small firms. The package is expected to lift GDP growth by 1.4 percentage points annually for three years, assuming full implementation.

Policy Dilemma for the Bank of Japan

The Bank of Japan faces a challenging policy balancing act as the government pushes for economic support. With inflation persistently above the central bank's 2% target and bond yields rising, the BoJ must weigh the risks of higher borrowing costs against the need to sustain growth. Governor Kazuo Ueda has signaled that a rate hike is likely later this month.

Despite the revised GDP contraction, the BoJ is expected to continue its gradual tightening path. The decline is seen as temporary, largely driven by one-off factors like housing regulation changes. However, the rise in Japanese government bond (JGB) yields has raised concerns about the country's fiscal sustainability. The 10-year JGB yield climbed to 1.94% recently, the highest level since 2007.

Rising Yields and Global Implications

The sharp rise in bond yields is forcing the BoJ to reconsider its strategy. If rates are raised further, yields could spike even higher, increasing Japan's borrowing costs and exacerbating its already dire fiscal position. Japan's public debt-to-GDP ratio is the highest in the world, and the government is set to issue 11.7 trillion yen in new debt to fund Takaichi's stimulus, more than double the amount issued under the previous administration according to market analysis.

Market participants are also watching how the BoJ manages the broader implications of rising yields. A repeat of the 2024 carry trade unwind is unlikely due to structural factors such as increased retail investment and stable pension fund flows. However, the narrowing yield gap between Japan and the U.S. is reducing the appeal of yen-funded carry trades, which could lead to episodic volatility.

Political and Social Pressures

Takaichi is under political pressure to demonstrate that the government is actively easing the cost of living for households. Previous leaders have been ousted over public discontent with inflation and stagnant wages. The prime minister's stimulus package is also designed to support labor negotiations, as unions push for continued wage increases after years of strong gains.

The government's focus on wage support is particularly important for smaller firms, which make up a significant portion of the Japanese economy. If the measures fail to alleviate inflationary pressures, Takaichi could face growing criticism from both the public and key economic stakeholders. The success of the stimulus package will also depend on how quickly it can be implemented and how effectively it is communicated to the electorate.

Outlook and Market Reactions

The Japanese economy is at a critical juncture. The revised GDP figures reinforce the need for immediate fiscal action but also highlight the challenges ahead. With inflationary pressures and rising bond yields, the BoJ and the government must carefully coordinate their efforts to avoid unintended consequences.

Markets are closely watching for any sign of policy divergence between the BoJ and the government. A misalignment could lead to increased volatility in the yen and Japanese government bond yields. Investors are also monitoring how Takaichi's stimulus affects consumer sentiment and business confidence in the coming months.