Japan Economic & Financial Weekly

Long-term and super-long-term JGB yield scenario for July

In July, we expect the JGB market to be caught between external factors pushingrates lower (an improved external environment) and domestic factors causing themto remain sticky or rise. When the former are stronger, the yield curve is likely tobull-flatten in the long- and super-long-term sectors; when the latter prevail, weanticipate a bear steepening of the curve. US President Donald Trump willprobably want to emphasize the “achievements” of the military strike on Iran onJuly 4, which is Independence Day and also marks the 250th anniversary of thenation’s founding. News reports claim that working-level talks between the US andIran will resume in Switzerland as early as June 30, with full-fledged negotiationson Iran’s nuclear program, the biggest point of contention between the twocountries, set to begin. Although the talks may become deadlocked again, bothnations appear to be placing priority for now on the resumption of navigationthrough the Strait of Hormuz. In its monthly Oil Market Report, released on June17, the International Energy Agency (IEA) projected that the global crude oil market would gradually recover following the reopening of the Strait and projected that2027 would bring “a significant [supply] overhang.” If progress is made in this area and crude oil prices tumble, expectations for higher global interest rates and monetary tightening could fade.

On the domestic front, concerns about the Takaichi administration’s economic policy blueprint are likely to weigh on the JGB market. The government presented a draft outline of the blueprint (the Basic Policy on Economic and Fiscal Management and Reform) at a meeting of the Council on Economic and Fiscal Policy (CEFP) on June 25 (Table 1). According to the draft, the government plans to formulate a new longer-term economic and fiscal plan for FY27-40 that centers on enhancing Japan’s growth potential and ensuring safety and security, and includes public- and private-sector investments totaling more than JPY370 trillion. The document does not specify how much the public sector will invest or how those investments will be funded. Additionally, expenditures considered important for economic security are to be drawn from a special account separate from the general account and will be funded with bridge bonds, for which repayment sources are specified from the outset. Bridge bonds are effectively special deficit-financing bonds and would initially lead to increased JGB issuance. The aggregate impact on JGB issuance from FY27 onward is unclear at this point. Discussions will also be held on how to fund the consumption tax cut on food products. The difficulty of assessing the impact on JGB supply/demand from FY27 onward may prompt bond investors to adopt a wait-and-see stance and refrain from active buying.

Attention should also be paid to the differences in views between the governmentand the BoJ and to monetary policy’s role in the Basic Policy, which is set to becompiled in July. Reuters reported on June 25 that the government has begundiscussions with an aim to indicating in the document its view that appropriatemonetary policy management that supports private demand is extremely important.According to the article, the government will also declare that near-term economicand fiscal management aims to achieve strong economic growth, and thatappropriate monetary policy supporting private demand and stable price increasesis crucial. This would underscore the Takaichi administration’s cautious stance onrate hikes. In response, the BoJ is expected to continue making a case for furtherrate rises, arguing that 1) price stability is essential for stable longer-term economicgrowth, 2) there will be a greater negative impact on the economy and financialmarkets if the central bank falls behind the curve and substantial rate hikes arerequired later, and 3) financial conditions remain accommodative. BoJ Policy Boardmember Naoki Tamura also cited Article 2 of the Bank of Japan Act in his speechon June 25 (“The Bank of Japan conducts currency and monetary control, aimingat achieving price stability”) and said, “In my view, it is the Bank's mission to serveas the guardian of price stability, while maintaining thorough communication withthe government.”

At this point, however, the government appears to be prioritizing an expansion ofinvestment, and if that process leads to a rise in inflation, it is likely to compensatehouseholds for the loss of real income through subsidies and tax cuts. It appears tobe aiming for a scenario in which, as these investments bear fruit, they expandsupply capacity and boost productivity, thus curbing inflationary pressures andlifting real incomes. It would appear that the government does not want the BoJ todampen companies’ appetite for investment through rate hikes. Incidentally, in aproposal for the 2026 Basic Policy compiled in mid-June by a LDP parliamentaryleague to promote responsible and proactive fiscal policy, the section 6(institutional and regulatory reforms) states that “with respect to the Public FinanceAct, the Ministry of Finance Establishment Act, the Bank of Japan Act, and otherlaws, operational issues in current structures and their consistency with the goalsof economic and fiscal management should be reviewed to provide longer-termsupport for responsible and proactive fiscal policy (translated by MUMSS).” Close attention should be paid to future discussions over whether the government andruling party seek fiscal dominance—effectively, government control over monetarypolicy. Fiscal affairs receive priority in such a regime, and the central bank is forced to place greater emphasis on fiscal stability than its original mandate of keeping inflation in check.