As the yen exchange rate returns to the intervention zone and government bond yields climb to three-decade highs, the Bank of Japan is facing its most severe test since launching quantitative tightening (QT) in 2024.
Recent signs indicate that to calm bond market volatility and alleviate fiscal pressure on the government, the central bank may pause its bond purchase reduction plan in the next fiscal year.
Since Governor Ueda took the helm, tightening the decade-long ultra-loose monetary policy has been a core agenda. However, the market's expectation for continuity is meeting resistance from reality. At the upcoming policy meeting on June 15-16, the Bank of Japan will review the progress of bond purchase reductions through next March and outline a new blueprint for fiscal year 2027.
Sources reveal that due to uncertainties from the Middle East situation and geopolitical conflicts, bond market sentiment remains extremely fragile. Currently, within the central bank, there is a tendency to maintain the current pace of bond purchases in the next fiscal year rather than further reductions. One insider stated bluntly, "Market volatility has not subsided, and there is no need to risk aggressively shrinking the balance sheet now."
Beyond market factors, pressure from the political center is significantly influencing the direction of monetary policy. Since Prime Minister Takaichi took office, the market has expressed concern over her substantial fiscal spending plans.
For the government, the immediate priority is to curb excessively rapid interest rate increases. Last week, the yield on Japan's 10-year government bonds touched a three-decade high of 2.8%, approaching the 3% reference line set by the Ministry of Finance when compiling the budget for fiscal year 2026. Once yields breach this "red line," the government's debt servicing costs could grow exponentially, squeezing the budget space for social welfare and economic stimulus packages. Former Bank of Japan official Atsushi Atago pointed out that against a backdrop of increasing political resistance, the central bank has no reason at all to persist with balance sheet reduction next year.
Amid bond market turbulence, the pressure from yen depreciation has once again become a shadow. The yen-to-dollar exchange rate is currently hovering around 160, which is the critical level that previously triggered large-scale official intervention.
Although Japan holds approximately $1 trillion in foreign exchange reserves and is suspected to have spent around $63 billion to support the yen from late April to early May, market skepticism remains widespread.
Daisaku Ueno, chief FX strategist at Mitsubishi UFJ Morgan Stanley Securities, warned that foreign exchange reserves are not inexhaustible. As ammunition is depleted, Japan might appear more vulnerable in the eyes of speculators.
A deeper constraint lies in international coordination. Large-scale intervention implies selling U.S. Treasuries, which requires tacit approval from Washington. If the U.S. expresses dissatisfaction, it could trigger a larger wave of selling.
The Bank of Japan is currently caught in a classic "impossible trinity": it needs to curb inflation and support the yen through rate hikes and balance sheet reduction, while also preventing a surge in long-term interest rates that could lead to fiscal collapse, all while responding to external geopolitical conflicts impacting trade conditions.
Next week, the Bank of Japan will release the minutes of its May meeting with bond market participants, which is seen as an important window for observing future policy intensity.
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