By Leika Kihara
TOKYO, May 29 (Reuters) - Bond market volatility is boosting the case for Japan's central bank to pause the unwinding of its massive debt holdings next fiscal year, which would give Prime Minister Sanae Takaichi some relief amid growing investor concerns about her spending plans.
A pause would mark a turning point in the Bank of Japan's quantitative tightening (QT) plan - in train since 2024 as part of Governor Kazuo Ueda's efforts to unwind a decade-long, massive stimulus.
At its June
15-16 meeting, the BOJ will review its bond taper plan running through March next year and lay out a new plan for fiscal 2027.
With no change expected to the existing taper plan, markets are focusing on whether the BOJ would keep reducing its monthly bond purchases in fiscal 2027 or maintain the current pace.
While there is no consensus yet within the BOJ on the final decision, a pause in taper is increasingly seen as the preferred option with uncertainty over the Iran war keeping bond markets jittery, said two sources familiar with the deliberations.
"Markets remain volatile, so there's no need to rush," one of them said on the BOJ's taper, adding that many market players appeared to favour maintaining the current pace of buying.
Political considerations may also incentivise the BOJ to pause as rising bond yields threaten to confine Takaichi's spending plans.
"What the administration wants to avoid most is rises in bond yields," said one of the sources.
GROWING CALLS TO PAUSE
Some investors are now calling on the BOJ to pause its bond taper plan, a central bank survey earlier this month showed, highlighting the challenge it faces in reducing its massive Japanese government bonds (JGB) holdings.
There had already been some indications the BOJ might consider slowing its taper plan amid market uncertainty.
A clearer signal on the BOJ's taper plan will come next week, when the central bank releases minutes of its meeting with bond market participants held on May 21-22.
"We've seen a pretty fast rise in bond yields, which makes it hard for investors to buy bonds. The finance ministry may be getting worried too," said former BOJ official Nobuyasu Atago.
"Given the political headwinds, I see no reason for the BOJ to keep tapering next fiscal year," he said.
Concerns over Japan's worsening finances and rising inflation pushed up the 10-year JGB yield to a 30-year high of 2.8% last week, nearing the 3% estimate the finance ministry set in compiling its fiscal 2026 budget. A rise above 3% would boost debt servicing costs and reduce scope for other spending.
The BOJ's rate-hike decision may also affect its taper plan with an increase in short-term rates to 1% from 0.75% seen as a strong possibility at the June meeting.
While the central bank has said its taper programme has no monetary policy implications, the case for slowing QT becomes stronger if it pushes through a hike, analysts say.
"With the bond market so unstable, it would be natural for the BOJ to play it safe and avoid causing undue market turbulence," said Mari Iwashita, executive rates strategist at Nomura Securities, who projects a taper pause in fiscal 2027.
"A combination of a taper pause and rate hike would be a good one," as the former will ease upward pressure on yields, while the latter would alleviate concern the BOJ is behind the curve in addressing inflationary risks, she said.
POLITICAL HURDLES
Rising debt and volatile yields have heightened challenges for central banks unwinding their balance sheets that ballooned from years of heavy asset purchases to reflate their economies.
In the U.S., analysts doubt whether new Federal Reserve chief Kevin Warsh can push through his calls for a smaller balance sheet as U.S. Treasuries lose their luster.
The BOJ has also been cautious in its QT programme that began in 2024, under which it gradually reduced purchases and currently trims monthly buying by 200 billion yen each quarter.
Political hurdles for the BOJ's QT have heightened under Takaichi, who has vowed to cut tax and boost spending with debt-backed funding.
Taper or not, a reduction in the BOJ's holdings, currently at around 500 trillion yen, will proceed steadily due to the runoff of maturing JGBs that already shaved 20% off its balance sheet from a peak in late 2023.
That's all the more reason for the BOJ to maintain the current pace of buying, said former BOJ executive Akira Otani, currently managing director at Goldman Sachs Japan.
"When inflationary risks from the Middle East conflict and the government's proactive fiscal policy are putting upward pressure on bond yields, proceeding with further tapering could cause political friction by pushing up yields," he said.
(Reporting by Leika Kihara; additional reporting by Tamiyuki Kihara, Makiko Yamazaki and Takahiko Wada; Editing by Sam Holmes)
