Japan Economic & Financial Weekly

JGB market outlook for October 26-30:Three hypotheses for recent decline in10-year JGB yield

The 10-year JGB yield could reverse higher in the week of October 26 if global risk aversion eases, depending on developments in AI-related equities, the situation in the Middle East, and French government bonds. On the other hand, it could fall further if investors grow more risk-averse. The 10-year yield had already dropped to 2.755% at the time of this writing, and a return to stability in overseas equity markets on Friday evening JST (October 23) could prompt a rebound early this week. But with the US midterm elections coming up on November 3 and the outcome difficult to predict, risk aversion is likely to persist even though there maybe some temporary reversals. An acceleration of stock market declines or gains in the yen could also fuel expectations of a delay in BoJ rate hikes and a lower terminal rate (see “BoJ watch” section below for a preview of the October Monetary Policy Meeting).

In the previous Japan Economic & Financial Weekly(“Will Takaichi administration’s rejection of reflationary stance help reduce risk premia?”), we wrote that “The Takaichi administration’s repeated rejection of reflationary policies may be helping to stabilize long- and super-long-term JGB yields by easing concerns about the BoJ falling behind the curve.” We also noted that “These developments could help compress the risk premia embedded in the long- and super-long-term sectors by easing concerns about the BoJ falling behind the curve. Although market participants are likely to remain skeptical of the administration’s true intentions, we think a temporary truce is possible until the government’s FY27 budget proposal and JGB issuance plan are unveiled.” Over the course of the week, concerns about the outlook for AI-related equities helped drive further declines in bond yields.

We offer the following hypotheses for the recent decline in yields. First, as noted above, Prime Minister Sanae Takaichi’s rejection of reflationary policies in the Diet and declaration of respect for the central bank’s autonomy have lowered the political hurdle for BoJ rate hikes, at least for the time being. This appears to have reduced the risk premia priced into long- and super-long-term yields by easing concerns that the Bank will fall behind the curve. At his press conference after the September 18 MPM, Governor Kazuo Ueda himself remarked that “interest rate conditions, particularly in the long- and super-long sectors, have tightened considerably” (translated by MUMSS). It would therefore be unsurprising if investors saw long- and super-long-term bonds, with their clearly positive real yields, as being attractively priced.

Second, we think the market may be preparing for a risk scenario. The so-called Core Weave shock has prompted investors to consider the possibility of a correction in risk asset prices, and particularly in AI-related equities. Although it is impossible to predict market developments, the Oct-Dec quarter, which marks the fiscal year-end for many US and European institutional investors, is often characterized by increased position adjustments and reduced liquidity. With so many uncertainties this year, including the US midterm elections, the events in the Middle East, and French fiscal and political developments, it would not be surprising to see stronger hedging-related demand for government bonds (with the exception of French OATs) as investors seek safe assets.

Third, domestic investors may be rebuilding their holdings of JGBs. September JGB trading data released on October 20 attracted attention because they showed city banks turning net sellers of coupon-bearing JGBs to the tune of JPY2.54 trillion(Graph 1). Their net sales of medium-term JGBs totaled just over JPY2.08 trillion, the largest figure since April 2016, and they were also net sellers of long- and super-long-term JGBs to the tune of JPY44.0 billion and JPY415.8 billion, respectively. Although the reasons for these sales are unclear, they may reflect position adjustments related to the 1H book-closing, in which case there could be scope for these banks to rebuild their holdings. Meanwhile, life and nonlife insurers were net buyers of coupon-bearing JGBs to the tune of JPY754.6 billion, marking a seventh consecutive month of net purchases. Purchases in the key super-long-term sector exceeded sales for a fourth straight month, with net purchases amounting to JPY532.0 billion (Graph 2). Insurers appear to be continuing to dispose of low-coupon bonds purchased in the past, and the volume of new investment seems to be gradually increasing.

The 10-year JGB yield fell to 2.755% in the morning session on Friday (October23). We had forecast a trading range of 2.85% - 3.40% for the Oct-Dec quarter(closing-yield basis), and the 10-year yield has now fallen below the lower bound. We projected the 10-year yield would put in a top in the current quarter and see room for both long- and super-long-term yields to move lower in FY27 as the end of the current hiking cycle comes into view. While a peak in yields before year-end would be consistent with our outlook, the speed of the decline in yields has exceeded our expectations, and we plan to consider revising our forecasts in the next issue of this report.

Forecast range (intraday basis):

10-year JGB yield: 2.700%–2.900%

30-year JGB yield: 3.700%–3.950%