Japan awaits two-year bond auction amid growing rate hike fears

Investors are on tenterhooks ahead of Japan’s two-year government bond auction on Thursday, amid speculation that the Bank of Japan may need to raise interest rates more aggressively to rein in inflation and support the yen.

The yield for the tenor fell 1.5 basis points to 1.085% in morning Tokyo trading, while yields for the 10-year bond are down 3 basis points. Those for longer tenors all dropped by as much as 4.5 basis points.

The auction comes less than a week after the BOJ lifted its policy rate to a three-decade high. In comments afterward, Governor Kazuo Ueda offered little guidance on the central bank’s future rate path, weakening the yen and sending yields sharply higher.

The two-year rate, which is more sensitive to monetary policy expectations, climbed earlier this week to its highest level since 1996. Meanwhile, the 10-year breakeven inflation rate — an important gauge of market expectations for future price pressures — jumped this week to the highest level in data going back to 2004.

“Inflation expectations and forecasts for the neutral rate are rising due to concerns that the BOJ is behind the curve,” said Katsutoshi Inadome, a senior strategist at Sumitomo Mitsui Trust Asset Management Co. “There’s some unease about the auction.”

To be sure, the yen’s depreciation and rising yields have calmed down since the start of the week after Japanese authorities’ verbal warnings on the currency, but the auction will serve as a key gauge of market views on the BOJ’s policy stance. Overnight index swaps show a certain chance of another rate hike by September of next year.

What Bloomberg strategists say:

The final 2-year debt sale for this year looks like it will be the first with a yield above 1%, but that still doesn’t guarantee a strong auction after last week’s interest-rate hike from the Bank of Japan.

Getting to a rate increase was a tortuous process for the BOJ. Yet, last week Governor Ueda hinted the central bank will be back to ground zero when it tries to persuade politicians that it is reasonable to hike again next year. Which is why traders are only pricing for the next 25-bp jump in September 2026.

— Mark Cranfield, Markets Live Strategist. Read more on MLIV.

Investors are also concerned about the government’s bond issuance plans tied to the fiscal 2026 budget, which is expected to be approved by the Cabinet on Friday. Japan’s primary dealers said this month that more issuance of two-, five- and 10-year government bonds is desirable for the next fiscal year, while calling for a reduction in sales of super-long debt.

Fresh bond issuance for the budget covering the year from April will stay under ¥30 trillion ($192 billion) but will exceed the current year’s initial ¥28.6 trillion issuance, according to people familiar with the matter.

“It’s not a good time to buy,” said Miki Den, a senior rates strategist at SMBC Nikko Securities. “There’s a high likelihood that two-year bonds will see increased issuance, so there’s a risk of incurring unrealized losses immediately after purchases.”

The auction results are due at 12:35 p.m. Tokyo time Thursday. Investors will closely watch the bid-to-cover ratio as a key gauge of interest — which came in at 3.53 at the previous sale in November. They will also look at the so-called tail, the spread between the average and lowest-accepted prices.