Japan’s bond-market tremble reflects a fiscal-monetary clash

Something is amiss with Japanese government bonds (JGBs). On January 20th the country’s longest-dated debt sold off sharply. The yield on 30-year bonds rose by a quarter of a percentage point, the most in a day since 1999. The 40-year yield pierced 4% for the first time. Though yields fell the next day, the trembling bond market will overshadow a meeting of the Bank of Japan (BoJ) on January 22nd and 23rd. As it should: investors have cottoned on to a clash between the central bank and Takaichi Sanae’s government.

The proximate cause of the turmoil is fear about fiscal policy. On January 19th Ms Takaichi, prime minister only since October, called an election for February 8th, seeking a mandate for what she calls “responsible and proactive” fiscal expansion. She promises a two-year suspension of the 8% consumption tax on food, and higher spending on defence and industrial policy. Suspending the food tax alone will cost ¥5trn ($32bn) a year, or 6% of the expected tax take in the latest fiscal year. Even if Ms Takaichi is thwarted at the polls, her embrace of tax cuts means that few in Japanese politics are urging fiscal restraint. (Her predecessor, Ishiba Shigeru, was a fiscal hawk.) Though Ms Takaichi says she will finance the tax cut without additional debt, investors are sceptical.

These days, they have good reason to worry. The JGB market is more reliant than ever on foreign buyers. This is especially so in the longest-dated debt (ie, with maturities of over ten years), the segment that sold off. In 2025 foreigners accounted for 53% of ultimate demand for long-dated government bonds, up from 22% before the pandemic. That is largely because traditional domestic buyers, such as insurers and the BoJ, have vanished. Many of them bought bonds for reasons other than return (because the BoJ was trying to reflate the economy, for example). The foreigners care primarily about price and yield.

In addition, inflation is nearly back to normal. Headline consumer prices have been rising faster than the BoJ’s 2% target for almost four years. Yet the central bank, determined to banish deflation for good, has raised rates only gingerly. Now there is evidence that inflation is becoming entrenched. “Japan’s underlying inflation [is] steadily approaching 2%,” said Ueda Kazuo, the BoJ’s governor, in December. He pointed to record corporate profits, mounting labour shortages, back-to-back years of bumper wage rises and fast-rising inflation expectations.

If Mr Ueda is right, then the BoJ’s policy of negative real (inflation-adjusted) interest rates is nearing its end. It will have to raise rates towards “neutral”, the point at which they neither stimulate the economy nor inhibit it. Its current nominal rate is 0.75%; estimates by central-bank researchers peg Japan’s neutral rate in the range of 1-2.5%, according to Goldman Sachs, another bank. That looks in line with the bond market’s bets. The ten-year yield—which incorporates bondholders’ best guess at average interest rates over the next decade—has risen to 2.2%, from a mere 0.6% two years ago.

This means monetary and fiscal policy are heading for a clash. Mr Ueda wants higher borrowing costs to lower inflation and strengthen the yen. Ms Takaichi wants fiscal expansion, probably entailing fresh borrowing. Either would worsen the squeeze on a government already saddled with net debt of 130% of GDP. Ms Takaichi has called rate hikes “stupid”. Her mentor, Abe Shinzo, ended a similar conflict in 2013 by forcing the BoJ into submission.

Ms Takaichi’s course risks higher inflation for some time to come, eroding the purchasing power of Japan’s households, while devaluing JGBs. Her timing is poor, too. Japan hardly needs stimulus: the government’s estimate of the “output gap”, a measure of how close the economy is running to its potential, is near zero. This is not Japan’s “Liz Truss moment”—panic driven by sudden fiscal laxity, as Britain experienced in 2022. Too many JGBs are owned domestically for capital flight to be a big risk. But investors are rightly wary. ■