A Japanese government source familiar with policy discussions revealed on Monday that the government intends to compile a supplementary budget to cushion the economic impact of the Middle East conflict, with part of the funding likely to be raised through new government bond issuance. This new debt issuance would further strain Japan's already deteriorating fiscal health and could accelerate the rise in long-term interest rates. Driven by these concerns, the yield on Japan's benchmark 10-year government bonds climbed to 2.8% on Monday, reaching its highest level since October 1996, while the 30-year bond yield also hit a record peak. Prime Minister Sanae Takaichi stated on Monday that she had instructed Finance Minister Mayumi Katayama last week to begin work on a supplementary budget, marking a shift from her previous stance of not ruling out such a measure. The funds from this supplementary budget are primarily intended for government subsidies to stabilize gasoline and utility costs. The conflict in the Middle East has driven up international oil prices, casting a shadow over Japan's economic outlook due to its heavy reliance on fuel imports from the region. The specific size of the supplementary budget's expenditures has not yet been finalized. This policy shift has raised questions about the government's commitment to maintaining sound and proactive fiscal management. Masaru Inatsugu, senior strategist at Sumitomo Mitsui Trust Asset Management, commented, "Prime Minister Takaichi had previously refused to consider a supplementary budget. The sudden change in stance has unsettled market sentiment, leading to a sell-off across the entire yield curve of Japanese government bonds." Yuichiro Tamaki, leader of an opposition party, proposed to the Ministry of Finance last Friday a supplementary budget of approximately 3 trillion yen ($189 billion), a figure that may serve as a reference point for subsequent discussions on the budget's scale. Inatsugu added, "There are ample reasons to sell Japanese bonds right now and few to buy. The market has begun to anticipate that this supplementary budget could reach 5 to 10 trillion yen." Japan currently uses subsidies to control gasoline prices and plans to reactivate utility cost subsidies using existing funds. The current fiscal year, which began in April, already features a record-high main budget of 122 trillion yen, a cornerstone of the Prime Minister's expansionary fiscal policy. The supplementary budget would represent additional spending on top of this. Industry critics warn that substantial new spending, combined with the Bank of Japan's gradual pace of interest rate hikes, could further fuel inflationary pressures. Japan's domestic inflation is already elevated due to rising energy costs from the Middle East conflict and higher import prices driven by a weak yen. On Monday, Japan's Nikkei stock average declined, and the yen weakened to 158.97 per U.S. dollar, its lowest level since April 29. Daisuke Uno, chief strategist at Sumitomo Mitsui Banking Corporation, noted, "Economies like Japan and the U.K. are particularly vulnerable to a triple sell-off of stocks, their currency, and bonds when they implement fiscal stimulus, largely because they face weak growth and high inflation risks." The Japanese government is expected to finalize the supplementary budget plan between June and July. During the same period, it will also announce an investment promotion plan and specific details regarding the two-year postponement of an 8% consumption tax rate on food items. The Bank of Japan faces a dilemma amid the bond sell-off. The central bank is scheduled to hold a policy meeting in June to discuss whether to raise its short-term policy rate from 0.75% to 1%. At the June meeting, the Bank of Japan will also review its existing plan to reduce bond purchases and unveil a new policy framework for the fiscal year 2027 and beyond. Driven by surging energy prices due to the conflict and higher import costs from yen depreciation, Japan's wholesale inflation rate rose to 4.9% in April, a three-year high, providing strong justification for a potential rate hike next month. Analysts suggest that the Bank of Japan has traditionally preferred to pause policy adjustments during periods of high market volatility. However, a prolonged delay in raising rates could heighten market concerns that the central bank is falling behind in addressing high inflation risks. The Bank of Japan has recently sent hawkish signals, and its April decision to hold rates steady included a dissenting vote. Markets currently estimate about a 70% probability of a rate hike in June. A Reuters survey indicates that nearly two-thirds of economists believe the Bank of Japan will raise rates in June. Mari Iwashita, chief market economist at Daiwa Securities, predicted, "If inflation risks intensify further, the Bank of Japan could raise the short-term policy rate to 1.5% by the end of this fiscal year in March, and the 10-year government bond yield could also approach 3%."
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