“Basic Policy” shock pushes long-term rates higher
The upswing in long-term interest rates has grown more pronounced since the start of this month. On July 7 Japan's 10-year government bond yield briefly climbed above 2.86%, its highest level in some 30 years.
The recent rise in long-term rates was triggered by media reports on the government's economic policy blueprint (the Basic Policy on Economic and Fiscal Management and Reform), which is scheduled for release in July. This has come to be referred to as the "Basic Policy" shock.
Reports that the draft version of the document will contain language perceived as discouraging further rate hikes by the Bank of Japan fueled expectations that rate hikes would be pushed back and weakened the yen. Speculation that delays in rate hikes would exacerbate the upside risks to inflation as the central bank fell behind the curve also weighed on bond prices and sent long-term yields higher.
Additionally, the government has indicated its intention to slash the consumption tax on food products and promote public- and private-sector investment in 17 key areas but has yet to explain how these measures will be funded. Nor has it indicated how large an increase in fiscal expenditures the public- and private-sector investments will entail. Moreover, speculation that the government will revise its fiscal consolidation target and effectively retreat from efforts to improve the nation’s finances has led to growing fiscal concerns and driven a simultaneous decline in the yen and JGBs.
The recent rise in long-term rates was triggered by media reports on the government's economic policy blueprint (the Basic Policy on Economic and Fiscal Management and Reform), which is scheduled for release in July. This has come to be referred to as the "Basic Policy" shock.
Reports that the draft version of the document will contain language perceived as discouraging further rate hikes by the Bank of Japan fueled expectations that rate hikes would be pushed back and weakened the yen. Speculation that delays in rate hikes would exacerbate the upside risks to inflation as the central bank fell behind the curve also weighed on bond prices and sent long-term yields higher.
Additionally, the government has indicated its intention to slash the consumption tax on food products and promote public- and private-sector investment in 17 key areas but has yet to explain how these measures will be funded. Nor has it indicated how large an increase in fiscal expenditures the public- and private-sector investments will entail. Moreover, speculation that the government will revise its fiscal consolidation target and effectively retreat from efforts to improve the nation’s finances has led to growing fiscal concerns and driven a simultaneous decline in the yen and JGBs.
Rise in real long-term rates may reflect concerns about nation’s finances
The 10-year JGB yield briefly fell back after climbing above 2.80% in May. It then resumed its advance in July, touching 2.86% on July 7.
During this period, market inflation expectations calculated from 10-year index-linked JGBs (JGBi's) slipped from 2.32% to 2.02%, most likely reflecting an easing of inflation concerns in the bond market as crude oil prices fell. The fact that the 10-year JGB yield nevertheless pushed higher during this period (when it might be expected to decline) probably reflects an increase in real long-term interest rates—nominal long-term rates minus long-term inflation expectations—rather than a rise in inflation expectations.
Real long-term rates also move higher when there are stronger expectations for BOJ rate hikes. However, speculation of near-term rate hikes actually faded during this period in response to the language concerning monetary policy in the Basic Policy draft. Accordingly, I think the recent rise in the 10-year JGB yield probably reflects concerns over a deterioration of the nation's finances, or perhaps market distrust of the government’s fiscal policy conduct.
During this period, market inflation expectations calculated from 10-year index-linked JGBs (JGBi's) slipped from 2.32% to 2.02%, most likely reflecting an easing of inflation concerns in the bond market as crude oil prices fell. The fact that the 10-year JGB yield nevertheless pushed higher during this period (when it might be expected to decline) probably reflects an increase in real long-term interest rates—nominal long-term rates minus long-term inflation expectations—rather than a rise in inflation expectations.
Real long-term rates also move higher when there are stronger expectations for BOJ rate hikes. However, speculation of near-term rate hikes actually faded during this period in response to the language concerning monetary policy in the Basic Policy draft. Accordingly, I think the recent rise in the 10-year JGB yield probably reflects concerns over a deterioration of the nation's finances, or perhaps market distrust of the government’s fiscal policy conduct.
Developments in Japan could once again upset global financial markets
Inflation expectations calculated from 2-year JGBi's are also high at 1.60%. Subtracting this figure from the 1% policy rate gives a negative real policy rate of -0.60%. However, the yield on the 10-year JGBi, which is a real interest rate, is already at the high level of 0.84%.
The BOJ’s current policy rate does not appear to be high enough to weigh on economic activity. But long-term interest rates, which have been driven higher by fiscal concerns, may already be acting as a drag on the economy by dampening business investment.
Before discouraging rate hikes out of consideration for the economy, the government should first strive to lower long-term interest rates by gaining the market’s trust in its fiscal policy.
Long-term rates in Japan increased this January due to fiscal concerns, which in turn pushed up long-term rates in the US. Japan effectively became a source of instability in global financial markets. At the time, the government is believed to have been urged by US Treasury Secretary Scott Bessent to conduct policy with due consideration for market stability. Something similar could happen going forward.
The BOJ’s current policy rate does not appear to be high enough to weigh on economic activity. But long-term interest rates, which have been driven higher by fiscal concerns, may already be acting as a drag on the economy by dampening business investment.
Before discouraging rate hikes out of consideration for the economy, the government should first strive to lower long-term interest rates by gaining the market’s trust in its fiscal policy.
Long-term rates in Japan increased this January due to fiscal concerns, which in turn pushed up long-term rates in the US. Japan effectively became a source of instability in global financial markets. At the time, the government is believed to have been urged by US Treasury Secretary Scott Bessent to conduct policy with due consideration for market stability. Something similar could happen going forward.
Government should heed market’s warning and work to ensure credibility of fiscal policy
Over the past several years, a cycle of a falling yen and rising prices has emerged, causing the yen to remain excessively cheap vs. other currencies. A weak yen lifts domestic prices by raising import prices, while inflation tends to generate further currency weakness by eroding the value of the currency.
On the other hand, reduced confidence in fiscal policy due to deteriorating national finances causes bonds to cheapen and thus pushes long-term interest rates higher. That serves to undermine trust in the currency and triggers a decline in the yen. Inflation caused by a weak yen also sends bond prices lower.
Before this cycle of a falling yen and rising prices develops into a cycle of a falling yen, rising prices, and falling bond prices and becomes entrenched, the government needs to heed the market’s warning and pursue fiscal policy that is worthy of the market's trust.
On the other hand, reduced confidence in fiscal policy due to deteriorating national finances causes bonds to cheapen and thus pushes long-term interest rates higher. That serves to undermine trust in the currency and triggers a decline in the yen. Inflation caused by a weak yen also sends bond prices lower.
Before this cycle of a falling yen and rising prices develops into a cycle of a falling yen, rising prices, and falling bond prices and becomes entrenched, the government needs to heed the market’s warning and pursue fiscal policy that is worthy of the market's trust.
Profile
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Takahide KiuchiPortraits of Takahide Kiuchi
Executive Economist
Takahide Kiuchi started his career as an economist in 1987, as he joined Nomura Research Institute. His first assignment was research and forecast of Japanese economy. In 1990, he joined Nomura Research Institute Deutschland as an economist of German and European economy. In 1996, he started covering US economy in New York Office. He transferred to Nomura Securities in 2004, and four years later, he was assigned to Head of Economic Research Department and Chief Economist in 2007. He was in charge of Japanese Economy in Global Research Team. In 2012, He was nominated by Cabinet and approved by Diet as Member of the Policy Board, the committee of the highest decision making in Bank of Japan. He implemented decisions on the Bank’s important policies and operations including monetary policy for five years.
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