Japan's borrowing costs have surged to their highest level in three decades, driven by investor concerns over persistent yen weakness and a massive long-term spending program that could worsen the country's enormous debt burden.
The nation's government bonds have faced heavy selling this year, with the benchmark 10-year yield climbing to 2.87% on Wednesday, a level not seen since 1996.
Investors note that policies related to Prime Minister Fumio Kishida's 14-year, $2.3 trillion spending plan are intensifying the sell-off in long-term bonds. Some market participants also worry that while the Bank of Japan raised interest rates to 1% last month, subsequent rate hikes may lag, potentially allowing inflation to exceed the central bank's 2% target.
"A cautious Bank of Japan on further monetary tightening, continued yen weakness, and market concerns over fiscal policy are all contributing to particular pressure on the long end of the Japanese government bond yield curve," said Alex Everett, investment director at Aberdeen Standard Investments.
Market anxiety over long-term risks is evident in the spread between 10-year and 2-year bond yields. This gap, which was below 1 percentage point in April, has now widened to 1.4 percentage points. In contrast, similar yield spreads in other major bond markets like the U.S. and Germany have remained stable or even narrowed recently.
Investors warn that the sharp rise in Japan's borrowing costs is putting pressure on its massive sovereign debt, which exceeds 200% of its gross domestic product. The yield on Japan's 30-year bond has surpassed 4% this year and is hovering near the intraday record high of 4.2% set in May.
"The current market dynamics reflect that Japan accumulated the world's largest sovereign debt pile on the expectation that money would be permanently free," said Stephen Jones, chief investment officer at Aegon Asset Management.
"The market is now completely unwinding that expectation... The Tokyo government now needs to refinance its past debt and fund future spending at a cost not seen by a generation," he added.
Stephen Spratt, a rates strategist at Societe Generale, said that observers of Japan's economy are concerned that the growth rate of government borrowing costs could outpace revenue growth, worsening the debt dynamic.
"We think the tipping point is after the 10-year yield breaks 3%, but once it touches 3%, questions will start to be asked across the market," he noted. Bond yields move inversely to prices.
A surprising development for fund managers this year has been the simultaneous decline of the yen and Japanese bond prices, which typically move in opposite directions due to interest rate expectations. Despite several interventions by the Bank of Japan to support the currency in recent months, the yen fell to a 40-year low last month. Inflation edged up to 1.5% ahead of the central bank's policy meeting last month.
"Inflation is no longer negligible, government borrowing remains high, and the Bank of Japan is still normalizing monetary policy. The combination of these factors is making the market highly sensitive to the fiscal situation for the first time in many years," said Fraser Lundie, head of fixed income at Aviva Investors.
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