With the market widely expecting the Bank of Japan to keep interest rates unchanged when it announces its rate decision on Friday, elevated yields have drawn investors in, resulting in strong demand at the auction of 2-year Japanese government bonds.
The bid-to-cover ratio for this auction came in at 4.03 times, the highest since June and above the 3.89 times recorded at the previous auction, as well as the 12-month average of 3.84 times.
Another sign of robust investor interest was that the auction's "tail" — the gap between the average accepted price and the lowest accepted price — stood at 0.014, unchanged from last month's auction.
Given that 2-year government bond yields are particularly sensitive to monetary policy expectations, investors are closely watching this maturity.
Hit by last month's global bond selloff, Japan's 2-year government bond yield briefly climbed to its highest level in decades before retreating slightly.
Ryutaro Kimura, a senior bond strategist at BNP Paribas Asset Management, said persistent concerns over France's debt problems, combined with uncertainty surrounding the outlook for artificial intelligence (AI)-related stocks, have kept demand for safe-haven assets alive, supporting the stable result of this auction.
He added that Friday's BOJ meeting could upgrade its assessment of underlying inflation in its statement, which may further confirm the central bank's stance of wanting to raise rates more quickly and reach a neutral interest rate level sooner.
Overnight index swaps show the market is currently pricing in roughly an 84% probability that the BOJ will raise rates before its December meeting.
Japan's underlying inflation gauge surged to a three-year high in September, further bolstering the case for the authorities to continue raising rates.
The BOJ may maintain a relatively rapid pace of rate hikes given that price trends remain as they are, while there is an internal view that the impact of rate increases on the economy has so far remained limited, according to people familiar with the matter.
Traders will be closely watching BOJ Governor Kazuo Ueda's press conference on Friday after the rate decision for signals on the pace and scope of further policy tightening ahead.
Mark Cranfield, a strategist at Markets Live, said the strong demand at today's 2-year JGB auction, above the average of the past year, suggests bond traders appear confident the BOJ will not adjust rates on Friday. This gives investors more time to continue enjoying the effect of a downward shift in the yield curve before the December monetary policy meeting. The weak 2-year note auction in August looks increasingly like an anomaly in the JGB auction calendar.
Meanwhile, the strategist noted that MUFG-MS was the largest buyer, a positive signal for secondary market trading. In addition, about 61% of buyers were unidentified, suggesting long-term portfolio investors may be providing support.
It is worth noting that, with signs of recovering domestic demand and a more favorable policy environment enhancing the appeal of high yields, global fund managers are once again showing interest in Japan's bond market.
T. Rowe Price Group Inc., which cut its Japanese government bond exposure earlier this year, has shifted to favoring long-duration bonds. Allianz Global Investors is selectively adding medium- and long-term bonds, while BNP Paribas Asset Management has built up super-long bond exposure.
This shift in attitude contrasts sharply with earlier this year, when even rising yields were not enough to dispel investor concerns: the market worried the BOJ was raising rates too slowly, fiscal spending was boosting government bond supply, and traditional domestic buyers remained on the sidelines.
Now, with the market expecting the BOJ to continue raising rates, insurance institutions are re-entering the bond market, and fund managers have more confidence to seize current high-yield opportunities.
T. Rowe Price portfolio manager Vincent Chung is currently bullish on the long end of the curve, betting that the yield curve will flatten in a BOJ rate-hiking environment. This marks a shift from earlier this year, when he bought Japanese government bonds in January after having been underweight for the previous year, only to cut exposure a month later as fiscal concerns intensified.
Vincent Chung now believes that, thanks to recent retail buying and the prospect of additional demand if proposed tax incentive measures are introduced, supply and demand will move toward a more balanced state by year-end.
Potential changes in the allocation of the Government Pension Investment Fund (GPIF) could provide another source of support, though he said any decision would depend partly on global market performance.
Fiscal policy remains the biggest obstacle to a further sustained bond market rally, and the government bond issuance plan for fiscal 2027 will test the recently revived market sentiment.
Investors are closely watching how the Japanese government will raise funds for food consumption tax cuts and expanded defense spending.
Vincent Chung said that if the budget plan fails to clarify funding sources, his bet on a flattening curve would be at risk.
Shoki Omori, chief Japan fixed income strategist at Deutsche Securities, warned that if a larger supplementary budget is introduced, or if the issuance plan fails to further reduce super-long government bond supply, the recent narrowing of long-bond spreads could reverse.
Brandywine Global Investment Management, which cut its Japanese government bond exposure earlier this year and sold its 30-year holdings, has not yet re-entered the market.
Portfolio manager Carol Lye said the Takaichi Sanae cabinet's downplaying of reflation rhetoric has helped stabilize yields, but investors are still waiting for a credible funding plan.
With the 10-year yield falling back below 3%, she also sees the possibility that demand could slow.
The BOJ will provide another test at its policy meeting on Friday. Officials are widely expected to keep rates unchanged, and investors will focus on Governor Kazuo Ueda's guidance on the pace of tightening and how far rates are from their eventual peak.
James McAlevey, global head of aggregate and absolute return at BNP Paribas Asset Management, believes that further confidence-building requires a "relatively restrained fiscal response" from the government and continued tightening by the BOJ.
He said the central bank does not necessarily need to hike this week, but a December move and continued "relatively hawkish" communication would be sufficient.
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