Since the outbreak of conflict in the Middle East in late February, Japan's government bond risk compensation indicator has risen the most among major bond markets, indicating that even if energy prices fall, domestic factors in Japan may continue to put pressure on its bonds. Data shows that since late February, the term premium for Japan's 10-year government bonds—the additional yield investors demand for holding longer-term bonds rather than continuously rolling over short-term securities—has surged by nearly 70 basis points. This increase is more than three times the rise in a similar indicator for U.S. Treasuries over the same period. Driven by concerns over inflation, fiscal policy, and the Bank of Japan's gradual interest rate hike path, the yield on Japan's 10-year government bonds briefly reached 2.80% last week, a three-decade high. This combination of factors suggests that even if a peace agreement between the U.S. and Iran leads to a decline in oil prices, Japanese bond yields may not necessarily fall consistently.
Akio Kato, senior manager of the strategic research and investment department at Mitsubishi UFJ Asset Management in Tokyo, stated that even if oil prices drop, the decline will only be gradual, and "there are also Japan-specific factors pushing up Japanese bond yields." He noted, "Even if the 10-year Japanese government bond yield falls below 2.5%, it will only be temporary." He further warned that by the end of this year, there is a risk that Japan's 10-year bond yield could exceed 3%. As of Monday, the yield on Japan's 10-year government bonds was reported at 2.695%.
Fiscal Concerns and Inflation Pressure The recent sell-off in Japanese government bonds, led by longer-term bonds, reflects two mutually reinforcing pressure lines. The first is the transmission of global inflation—war-driven energy price increases are pushing up borrowing costs for governments worldwide, and Japan is no exception. The second is domestic fiscal concerns. Japanese Prime Minister Takaichi Sanae called for a supplementary budget this month to address rising commodity prices, sparking market worries about the Japanese government's fiscal discipline. Analysis indicates that market concerns over the expansion of Japan's fiscal deficit have raised the "fiscal risk premium," becoming a significant driver behind the rise in Japanese bond yields.
Since Takaichi Sanae became the president of the Liberal Democratic Party in October 2025, her proposed proactive fiscal policies have cumulatively increased the yields on 10-year and 30-year government bonds by over 1 percentage point. A report from the Organisation for Economic Co-operation and Development (OECD) previously stated that as of 2024, Japan's total public debt had reached about 206% of GDP, the highest among OECD members. Data from Japan's Ministry of Finance shows that the ratio of the Japanese government's total debt to GDP is nearly 250%. The report warned that Japan should rely more on measures such as increasing consumption taxes to improve its fiscal situation, rather than further expanding fiscal expenditures. However, the Takaichi government has chosen the opposite path.
Mari Iwashita, an interest rate strategist at Nomura Securities, pointed out, "For a country with high debt like Japan, expanding fiscal spending while the central bank gradually exits its easing policy is akin to sending a signal to the market of 'raising interest rates with the left hand while borrowing with the right hand.' The long-end rates of Japanese government bonds are being repriced accordingly."
At the same time, the Bank of Japan's slow approach to raising interest rates may also lead to inflation remaining elevated for a longer period. Fiscal stimulus and potential political pressure for the Bank of Japan to tighten policy gradually have heightened investor concerns—even as price pressures rise, Japan is attempting to maintain overheated economic demand. Eiji Doke, chief bond strategist at SBI Securities in Tokyo, said, "The Takaichi government is pursuing high-pressure economic policies, so it hopes the Bank of Japan will be cautious about raising interest rates." He added, "The stronger the inflationary pressure and the higher inflation expectations rise, the more likely Japan is to fall behind the curve in policy."
In fact, even before the outbreak of the Middle East conflict, inflation expectations in Japan's bond market had been rising, indicating that price pressures may be structural rather than merely cyclical. Last month, the Bank of Japan revised its core inflation forecast for fiscal year 2026 (April 2026 to March 2027), excluding fresh food, from 1.9% predicted in January to 2.8%. However, data released last Friday showed that Japan's national core CPI (excluding fresh food) rose 1.4% year-on-year in April, not only below the market expectation of 1.7% but also significantly lower than the 1.8% in March, hitting a four-year low since March 2022. The overall CPI was also 1.4%, below the expected 1.6%. This marks the fourth consecutive month that Japan's inflation rate has been below the central bank's 2% policy target.
On the surface, April's inflation data showed a "broad cooling." The overall CPI fell to 1.4%, the core CPI dropped to 1.4%, and the "core-core CPI" (excluding fresh food and energy prices), which better reflects underlying demand-side price changes, rose 1.9% year-on-year, down from 2.4% in March, reaching a 14-month low. However, a breakdown of the structural details behind the data reveals that inflationary pressures are far from subsiding.
First, the decline in inflation is not due to shrinking demand but the result of strong policy interventions. Government policies such as tuition subsidies have suppressed one-time expenditure items like private high school fees, while energy subsidies continue to buffer the transmission of international oil prices to end consumers. Once these subsidies are withdrawn, suppressed prices are likely to rebound at a faster pace.
Second, as a leading indicator of consumer prices, the corporate goods price index (CGPI) surged 4.9% year-on-year in April, hitting a three-year high. Import prices rose 17.5% year-on-year, with energy prices and a weaker yen jointly driving up imported inflation. Bank of Japan board member Junko Kozue noted that companies are "significantly faster" in passing on costs through price increases compared to the past, a view entirely consistent with Bank of Japan Governor Kazuo Ueda's earlier remarks last week.
Finally, a more hidden structural variable comes from the AI industry. On May 21, Bank of Japan board member Junko Onoda explicitly warned in a speech to business leaders in Fukuoka that strong AI demand may be pushing up energy prices, meaning "prices of many goods may rise across the board in the future." As a key player in the global AI supply chain, Japan benefits from AI-driven semiconductor export growth (chip exports surged 44% year-on-year in April) but also faces increased electricity demand from AI data centers. This incremental demand, combined with energy supply disruptions in the Middle East, creates a "dual pressure from inside and outside," exposing Japan, a country highly dependent on energy imports, to unprecedented inflationary complexity.
Additionally, affected by turmoil in the Middle East, Japan's crude oil imports in April fell sharply by 64% year-on-year. The reduction in total energy imports, in terms of data, actually lowered the overall inflation reading. In other words, part of the "credit" for the decline in April's CPI comes from physical contraction on the supply side, rather than cooling demand—this contradiction itself suggests that the potential for future inflation rebound is accumulating.
What Will the Bank of Japan Decide? The Bank of Japan will hold its next monetary policy meeting on June 15-16. At that time, the monetary policy committee will face not only an interest rate decision but also a systemic choice of how to balance economic slowdown, fiscal expansion, international oil price shocks, and yen depreciation.
The Bank of Japan is facing a typical policy dilemma. On one hand, economic growth is slowing (the GDP growth forecast for fiscal year 2026 has been revised down from 1.0% to 0.5%), and raising interest rates could suppress a recovery that is not yet solid. On the other hand, although core inflation appears to be softening on the surface, imported inflationary pressures are accumulating—the U.S.-Iran conflict is driving up energy costs, AI demand is accelerating electricity consumption, companies are speeding up the pass-through of wage and raw material costs, and yen depreciation continues to amplify the effect of import prices.
Last month, the Bank of Japan kept interest rates unchanged at 0.75% to assess the impact of the Middle East war. However, three of the nine monetary policy committee members dissented and advocated for a rate hike to 1%, showing policymakers' growing vigilance over inflationary pressures triggered by the energy shock from the Middle East conflict. At a press conference after the April meeting, Governor Kazuo Ueda explicitly stated that the central bank would avoid "falling behind the curve" in fighting inflation and emphasized that if the economy does not slow significantly, a rate hike is "a realistic possibility."
At the same time, the Bank of Japan must also weigh external factors: explicit pressure from the U.S. to raise interest rates, global bond markets demanding higher term premiums, and market concerns over Japan's fiscal sustainability driving up long-term rates. Analysts point out that with Japan's inflation persistently above target, yen depreciation exacerbating imported inflation, and the global monetary policy tightening environment, the Bank of Japan would have logical support for raising interest rates next month.
However, the Bank of Japan still has multiple concerns regarding a rate hike decision. First, the foundation for domestic economic recovery is very fragile, and a rate hike could easily further suppress weak domestic demand and corporate investment. Second, Japan's government debt is massive, and a rate hike would significantly increase fiscal interest payment pressure, endangering debt stability. Third, under long-term low interest rates, financial institutions hold large amounts of government bonds, and a rate hike could trigger asset valuation losses, impacting the stability of the financial system, while also needing to balance the pace with expansionary fiscal policies.
Analysis suggests that the most likely approach for the Bank of Japan is to "raise rates slightly and emphasize gradualism." The central bank will not return to aggressive tightening but will use one rate hike to stabilize inflation expectations, while using dovish rhetoric to prevent long-term rates from spiraling out of control. However, the market does not rule out the possibility that the Bank of Japan may "disappoint" again. Analysis indicates that if the Bank of Japan postpones a rate hike next month, Japanese bond yields may experience a short-term, phased decline, with market expectations for monetary policy tightening cooling temporarily, and the sentiment of concentrated selling in the bond market may ease somewhat. But in the long run, Japanese government bond yields are unlikely to trend downward and are more likely to remain high or even continue to rise.
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