The latest auction of 2-year government bonds revealed mounting tensions in the short-term debt segment. Demand was weaker than usual (bid-to-cover of 3.53 versus the average of 3.66), and the difference between the highest accepted and the average price rose to 0.012 (compared to 0.002 a month earlier). The yield on 2-year bonds reached 0.975%, the highest since 2008. This is a clear signal that the market is reluctant to engage in low-yield securities given the possibility of further rate hikes.
Fiscal stimulus, but “controlled”
In parallel, Prime Minister Sanae Takaichi’s government approved an additional fiscal package worth 18.3 trillion yen. The funds are intended for households and increased military spending. The program is financed mainly through short-term debt – the issuance of 2- and 5-year bonds will increase by 300 billion JPY, and treasury bills by 6.3 trillion JPY. Additionally, higher-than-expected tax revenue and unspent funds from the previous year will be used.
Although short-term debt will rise nominally, total debt issuance for the 2025/26 fiscal year will fall to 40.3 trillion JPY from 42.1 trillion the year before. The government aims to demonstrate that it is conducting responsible fiscal policy, avoiding a return to pandemic-era excess.
Geopolitical factors Increase risk aversion
Japan’s economy, however, may encounter external obstacles. Deteriorating relations with China – especially in the context of Prime Minister Takaichi’s remarks about readiness to respond militarily in the event of aggression toward Taiwan – are raising serious investor concerns. Goldman Sachs estimates that a decline in tourism from China could lower GDP growth by 0.2 percentage points, while restrictions on the export of consumer goods could reduce it by another 0.1 percentage points. A potential escalation of sanctions could have a much larger and difficult-to-quantify impact.
Yen in retreat – but for how long?
In the last quarter, the yen weakened by 5.6% against the dollar, becoming the weakest currency among the G10. The prevailing narratives in the market are expectations that the BOJ will refrain from raising rates and that Japan will lose control over its public debt. However, both of these assumptions are beginning to lose relevance.