BOJ's rate path collides with Takaichi's bond market worries

The Bank of Japan's path toward higher interest rates is increasingly entangled with political pressure to keep the bond market stable, as the government of Prime Minister Sanae Takaichi pushes back against the central bank's balance-sheet reduction.

Concerns over Takaichi's expansive fiscal agenda have pushed Japanese government bond yields higher, raising borrowing costs for the world's most heavily indebted developed nation. The premier has pledged to improve communication with markets to preserve confidence in Japan's finances, and her allies have voiced unease over the BOJ's tapering programme.

At the central bank's June policy meeting, Economy Minister Minoru Kiuchi, a reflationist ally of Takaichi, warned of the economic consequences of the BOJ's balance-sheet reduction and urged policymakers to prioritise market stability. A separate aide has said the administration pays "very high" attention to bond yield moves and has relayed investor concerns over the "too-rapid" tapering.

Some analysts believe this pressure may have already shaped policy. In June, the BOJ paired a rate hike with a suspension of its bond-taper plan from the next fiscal year.

For the BOJ, however, resuming heavy bond buying would undermine years of work to exit extraordinary stimulus. The central bank ended yield-curve control in 2024 and launched a tapering programme as part of its normalisation strategy. Reversing course could damage the credibility of that transition and the effort to revive a market long dormant under heavy state purchases.

The BOJ has said it would only step up bond purchases through emergency operations if yields rise in a disorderly manner disconnected from economic fundamentals and threatening financial stability. In a recent research paper, it argued that rising inflation, not its slowing purchases, was the primary driver of higher yields.

Minutes from the June meeting show board members beginning to discuss the eventual size of the BOJ's balance sheet, signalling continued commitment to normalisation. One member warned that bond buying aimed at monetising debt or lowering yields could hurt the central bank's credibility.

Former BOJ official Nobuyasu Atago said such detailed discussions suggest policymakers may be preparing to publish estimates of an eventual balance-sheet target, which would help defend against accusations of bowing to government pressure.

Yet markets may ultimately force the BOJ's hand. The 10-year JGB yield rose to 2.805% on Monday, approaching the 3% level some analysts see as a trigger for fresh selling. While the BOJ is not targeting any specific yield, it could intervene if moves become rapid and one-sided enough to threaten financial stability, according to a source familiar with its thinking.

"The BOJ could have no choice but to step in if a dearth of demand for bonds among domestic investors triggers a spike in yields," said Mari Iwashita, executive rates strategist at Nomura Securities. "It's the cost the BOJ is paying for dominating the bond market for such a long time with prolonged monetary loosening."