Japan’s record bond yields pose policy problems for the Bank of Japan

Japan’s central bank is in a bind as a sharp rise in government bond yields risks disrupting the policy normalization process.

The Bank of Japan faces a tough choice: stick with its policy of raising interest rates and risk higher yields, further slowing an already weak economy, or continue lowering, or even cutting, rates to support growth, which could further accelerate inflation.

Japanese government bonds have been hitting new highs for the past month. On Thursday, the yield on the benchmark 10-year Treasury note hit a high of 1.917%, surging to its highest level since 2007. The 20-year Treasury yield hit 2.936%, the highest level since 1999, while the 30-year Treasury yield hit an all-time high of 3.436%, LSEG data dating back to 1999 showed.

As part of policy normalization, Japan will abandon its yield curve control program that capped the benchmark 10-year bond yield at around 1% in March 2024, ending the world’s last negative interest rate system.

Inflation has now exceeded the Bank of Japan’s 2% target for 43 consecutive months, raising concerns that bond yields will rise further as the country considers raising interest rates amid rising inflation.

Anindya Banerjee, head of currencies and commodities at Kotak Securities, told CNBC’s “Inside India” that if the Bank of Japan returns to quantitative easing and YCC, which limits bond yields, it could weaken the yen, which is already a problem, and add to imported inflation.

A rise in government bond yields means an increase in Japan’s borrowing costs, putting further pressure on Japan’s fiscal situation. Asia’s second-largest economy already has the world’s highest debt-to-GDP ratio, at around 230%, according to International Monetary Fund data.

Add to that concerns over Japan’s mounting debt, with the government poised to roll out the biggest stimulus package since the pandemic to rein in living costs and prop up Japan’s struggling economy.

Magdalen Teo, head of Asian bond research at Julius Baer, ​​said the 11.7 trillion yen in new government bonds issued to finance Prime Minister Sanae Takaichi’s supplementary budget is 1.7 times the amount issued in 2024 under the predecessor Shigeru Ishiba’s administration.

“This highlights the difficulties governments face in balancing economic stimulus with maintaining fiscal sustainability,” Teo said.

In August 2024, a hawkish Bank of Japan rate hike and disappointing US macro indicators led to an unwinding of yen-funded leveraged carry trades, causing stock prices to fall globally, with Japan’s Nikkei Stock Average dropping 12.4%, its worst day since 1987.

A carry trade refers to borrowing in a currency with a low interest rate and investing in a high-yield asset, and because Japan has a negative interest rate policy, the Japanese yen is the main source of funding for such transactions.

Now, rising Japanese yields have narrowed interest rate differentials, raising concerns that the unwinding of carry trades and the repatriation of funds to Japan could begin again. But experts say a repeat of the 2024 meltdown is unlikely.

“Globally, the narrowing of the U.S.-Japan yield differential makes carry trades with yen funds less attractive, but we do not expect a repeat of the systemic unwind in 2024. Rather, we should expect temporary volatility and selective deleveraging, especially if a stronger yen accelerates funding costs,” said Masahiko Lu, senior fixed income strategist at State Street Investment Management.

Lu’s attributes said structural flows driven by allocations to individuals from pension funds, life insurance and NISA (Japanese Individual Savings Accounts) have locked down overseas holdings, making large-scale repatriation unlikely.

Justin Heng, Asia-Pacific rates strategist at HSBC, agreed, saying Japanese investors remained net buyers of foreign bonds, with little sign of repatriation.

According to HSBC, the amount of overseas bond purchases from January to October 2025 was 11.7 trillion yen, far exceeding the 4.2 trillion yen purchased in all of 2024. The surge has been driven primarily by trust banks and asset management companies, which have benefited from inflows from individuals under the Japanese government’s tax-free investment program.

“We expect continued declines in hedging costs as a result of further Fed rate cuts are also likely to encourage Japanese investors to increase foreign debt exposure,” Heng said.