Since the outbreak of conflict in the Middle East in late February, Japan's government bond risk compensation indicator has recorded the highest increase among major bond markets. This suggests that even if energy prices decline, domestic factors in Japan may continue to exert pressure on its government bonds. Data shows that since late February, the term premium for Japan's 10-year government bonds—the extra return investors demand for holding longer-term bonds over rolling short-term securities—has surged by nearly 70 basis points. This increase is more than three times the rise in the comparable indicator for U.S. Treasury bonds over the same period. Driven by concerns over inflation, fiscal policy, and the Bank of Japan's gradual interest rate hike path, Japan's 10-year government bond yield recently touched 2.80%, a three-decade high. This combination of factors means that even if a peace agreement between the U.S. and Iran leads to lower oil prices, Japanese bond yields may not necessarily see a sustained decline. Akio Kato, senior manager of the strategic research and investment department at Mitsubishi UFJ Asset Management in Tokyo, stated that any decline in oil prices would likely be gradual, and "there are also Japan-specific factors driving up Japanese government bond yields." He noted, "Even if Japan's 10-year yield falls below 2.5%, that would likely be only temporary." He also pointed out that there is a risk of Japan's 10-year government bond yield exceeding 3% by the end of this year. As of Monday at the time of writing, Japan's 10-year government bond yield stood at 2.695%.
Fiscal Worries and Inflation Pressure The recent sell-off in Japanese government bonds, particularly in longer-term maturities, reflects two mutually reinforcing pressure lines. The first is global inflation transmission—war-driven energy price increases are pushing up borrowing costs for governments worldwide, and Japan is not immune. The second is domestic fiscal concerns. Japanese Prime Minister Sanae Takaichi's call this month for a supplementary budget to address rising commodity prices has sparked market worries about the 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 rising Japanese bond yields. Since Takaichi assumed leadership of the Liberal Democratic Party in October 2025, her advocated active fiscal policies have contributed to cumulative increases of over 1 percentage point in both 10-year and 30-year government bond yields. A previous OECD report noted that as of 2024, Japan's total public debt reached about 206% of GDP, the highest level among OECD members. Data from Japan's Ministry of Finance shows the ratio of the Japanese government's total debt to GDP is nearly 250%. The report warned that Japan should rely more on measures like raising consumption taxes to improve its fiscal situation rather than further expanding fiscal spending. However, the Takaichi administration has chosen the opposite path. Mari Iwashita, interest rate strategist at Nomura Securities, noted, "For a country with high debt like Japan, expanding fiscal spending while the central bank gradually exits easing is akin to signaling to the market 'raising interest rates with one hand while borrowing with the other.' The long-end rates of Japanese government bonds are repricing this."
Simultaneously, the Bank of Japan's slow pace of interest rate hikes could 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 are jointly exacerbating investor concerns—that Japan is attempting to maintain overheated economic demand even as price pressures rise. Eiji Doke, chief bond strategist at SBI Securities in Tokyo, stated, "The Takaichi administration is pursuing high-pressure economic policies, so it hopes the Bank of Japan will be cautious about raising rates." "The stronger the inflation pressure and the higher inflation expectations rise, the more likely Japan is to fall behind the curve in policy." In fact, even before the Middle East conflict erupted, inflation expectations within Japan's bond market had been steadily rising, suggesting 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, upward to 2.8% from the 1.9% predicted in January this year. However, data released last Friday showed Japan's nationwide core CPI (excluding fresh food) rose 1.4% year-on-year in April, not only below market expectations of 1.7% but also a significant drop from March's 1.8%, 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 Japan's inflation rate has fallen below the central bank's 2% policy target. On the surface, April's inflation data showed "broad-based cooling"—overall CPI fell to 1.4%, core CPI fell 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, examining 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 rather the result of strong policy intervention. Government measures like tuition subsidies have lowered one-time expenditure items such as 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, the Corporate Goods Price Index (CGPI), a leading indicator for consumer prices, 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 pushing up imported inflation. Bank of Japan board member Junko Kozue noted that companies are passing on costs through price increases at a "significantly faster" pace than in 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, implying that "prices for many goods may rise across the board in the future." As a key participant 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 "pincer movement" that subjects Japan, a highly energy-import-dependent economy, to unprecedented inflationary complexity. Additionally, affected by Middle East turmoil, Japan's crude oil imports plummeted 64% year-on-year in April. The reduction in total energy import value, in data terms, actually lowered the overall inflation reading. In other words, part of the "credit" for April's lower CPI comes from physical contraction on the supply side, not cooling demand—this contradiction itself suggests that momentum for future inflation rebound is building.
What Will the Bank of Japan Choose? The Bank of Japan will hold its next monetary policy meeting on June 15-16. At that time, the Monetary Policy Board 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 faces a classic 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 rates could suppress a recovery that is not yet solid. On the other hand, while core inflation appears soft on the surface, imported pressures are continuously building—U.S.-Iran conflict pushes up energy costs, AI demand accelerates electricity consumption, companies are speeding up passing on wage and raw material costs, and yen depreciation continues to amplify import price effects. Last month, the Bank of Japan kept its policy rate unchanged at 0.75% to assess the impact of the Middle East war. However, three of the nine Monetary Policy Board members dissented, advocating for a rate hike to 1%, showing policymakers' growing vigilance over inflation pressures triggered by the energy shock from the Middle East conflict. Following the April meeting, Governor Kazuo Ueda explicitly stated at a press conference that the bank would avoid "falling behind the curve" in fighting inflation and emphasized that a rate hike "is a realistic possibility" if the economy does not slow significantly. At the same time, the Bank of Japan must also weigh external factors: explicit U.S. pressure to raise rates, global bond markets demanding higher term premiums, and market concerns over Japan's fiscal sustainability are pushing up long-end yields. Analysts point out that with Japan's inflation persistently above target, yen depreciation exacerbating imported inflation, and the global monetary tightening environment, the Bank of Japan would have logical support for a rate hike 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; raising rates could easily further suppress weak domestic demand and corporate investment. Second, Japan's government debt is massive; raising rates would significantly increase fiscal interest payment pressure, endangering debt stability. Third, under prolonged low rates, financial institutions hold significant government bond positions; raising rates could trigger asset valuation losses, impacting financial system stability, while also needing to balance the pace with expansionary fiscal policy. Analysis suggests the Bank of Japan's most likely approach is a "small rate hike, emphasizing gradualism." The Bank of Japan will not return to aggressive tightening but will likely use one hike to stabilize inflation expectations while employing 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 might "disappoint" again. Analysis indicates that if the Bank of Japan postpones a rate hike next month, Japanese bond yields might see a short-term, phased decline, with market expectations for monetary policy tightening cooling temporarily, potentially easing concentrated selling sentiment in the bond market. But in the long run, Japanese government bond yields are unlikely to trend downward and will likely remain high or even continue to rise.
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