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"Summer Battle, Act Two" in JGB market: Will BoJ signal possible resumption of rate hikes?
Long-term and super-long-term JGB yield scenario for August
Long-term and super-long-term JGB yield scenario for August We see the 10-year JGB yield trending higher from its July range through the end of August. The market may have gone too far in pricing in an early resumption of BoJ rate hikes, and it would not be surprising to see some short-term pullback after the Monetary Policy Meeting on July 30-31. However, concerns about fiscal expansion could resurface toward the end of August due to an increasingly uncertain domestic political environment, potentially exerting steepening pressure on the super-long sector again. Different segments of the yield curve are likely to be driven by different themes; the short- and medium-term sector by rate hike expectations and the super-long sector by fiscal concerns.
Since the April "tariff shock," the JGB market has seen a tug-of-war between fading expectations of a BoJ rate hike and concerns over fiscal expansion. Although the ruling coalition lost its majority in the July 20 Upper House election, this outcome had already been priced in during the bear steepening that lasted through the middle of the week before the election. That, coupled with Prime Minister Shigeru Ishiba’s announcement of his intention to remain in office, prompted some buybacks in the super-long sector. Additionally, the surprise news of a US-Japan tariff agreement on July 22, coupled with hawkish comments from BoJ Deputy Governor Shinichi Uchida,1rapidly boosted expectations of a rate hike within the year (in a retreat from "fading rate hike expectations"). On July 24, the yield curve underwent a recently rare bear/bull flattening.
However, the market’s expectations of an early rate hike seem somewhat overdone in the short term and may temporarily subside. While the deputy governor described the US-Japan tariff agreement as "a significant step forward" (Jul 23), he also noted that negotiations between the US and other countries are still ongoing and said the impact of tariffs on domestic and global economies is "difficult to judge based solely on current data." We expect the BoJ will scrutinize the economic impact of the new tariff rates after they are applied to Japan and other countries starting on August 1. The Bank is likely to avoid any hasty decisions given the current political uncertainty. At the July 30-31 MPM, we think it will express relief over the tariff agreement but maintain a cautious stance on the outlook for economic activity and prices. Additionally, US Treasury Secretary Scott Bessent stated on July 23 that Japan’s adherence to the agreement will be reviewed quarterly, and "if President (Donald) Trump is dissatisfied, tariffs on automobiles and other products will revert to 25%." Furthermore, Japan’s pledge of USD550billion (approximately JPY80 trillion) in new investment in the US is reported to bea target that must be achieved during President Trump’s term of office, i.e., within the next three and a half years (Kyodo News). The feasibility and appropriateness of such a pledge have yet to be properly evaluated.
We will be closely monitoring domestic political developments this summer. Prime Minister Ishiba has expressed his intention to remain in office, but calls for him to take responsibility for the election loss are gaining traction within the LDP. Yomiuri reported on July 25 that "a petition is being circulated within the party calling for a general meeting of both Houses to seek accountability, and the backlash from local party organizations shows no signs of retreating." LDP rules state that an early presidential election (effectively a recall) can be held if demanded by a majority of party lawmakers and one representative from each prefectural branch federation. The opposition could also in theory pass a no-confidence motion against the cabinet if the various parties worked together. However, even if Mr. Ishiba steps down and a new LDP president is elected, the ruling coalition's loss of a parliamentary majority means there is no guarantee that it would be able to select the next prime minister. Depending on how the opposition responds, Japan could find itself with a government centered on opposition parties instead of the LDP. As political uncertainty deepens, expectations for an early resumption of BoJ rate hikes may be held in check, while concerns over a widening fiscal risk premium could reignite bear-steepening pressure on the JGB curve.
We have raised our forecast ranges and quarter-end point forecasts for super-long JGB yields by 10-20bp. With the domestic political landscape expected to remain fluid for now, we have priced in an elevated fiscal risk premium.
