With borrowing costs rising rapidly and government bond yields surging to levels unseen in decades, the Bank of Japan (BOJ) is confronted with nudging interest rates higher - risking even steeper yields and more pressure on a fragile economy - or pausing, possibly even easing, which could fan inflation.
Yields on Japanese government bonds have been climbing steadily, with the 10-year benchmark touching 1.917% on Thursday, the highest since 2007.
Longer-dated bonds have followed suit: the 20-year hit 2.936%, a level last reached in 1999, while the 30-year rose to a record 3.436%, according to LSEG data.
The BOJ scrapped its long-running yield curve control framework in March 2024, abandoning the cap that kept 10-year yields around 1%.
While that shift coincided with the end of Japan’s negative interest rate era, inflation has now stayed above the bank’s 2% target for more than three and a half years,
This is adding pressure on policymakers to tighten further as higher yields threaten to spiral.
Analysts warn that a return to aggressive bond-buying or yield caps could weaken the yen again, pushing up the price of imports, a problem Japan is already dealing with.
Meanwhile, rising yields inflate the government’s borrowing costs, with Japan’s debt currently sitting at around 230% of GDP, the highest in the world.
In response to this dilemma, Tokyo is preparing its biggest stimulus package since the pandemic to help households and revive sluggish growth.
That means even more bond issuance and further strain on public finances.
Julius Baer’s Magdalene Teo told CNBC that the 11.7 trillion yen in new bonds earmarked to fund Prime Minister Sanae Takaichi’s supplementary budget is significantly larger than last year’s issuance.
Some investors remember the sharp market turmoil in August 2024, when a BOJ rate hike and weak U.S. data set off a global sell-off.
The Nikkei plunged more than 12% in its worst day since 1987 after leveraged yen carry trades rapidly unwound.
These trades involve borrowing in yen at low interest rates and investing elsewhere for higher returns—a strategy that becomes less attractive as Japanese yields rise.
However, analysts remain optimistic that Japan won’t experience a repeat of that dramatic shake-out.
State Street’s Masahiko Loo argues that long-term investors such as pension funds and insurers help stabilise foreign holdings, making a mass return of funds to Japan less likely.
HSBC’s Justin Heng added that Japanese investors continue to buy overseas bonds rather than bring money home.
Between January and October 2025, they snapped up 11.7 trillion yen in foreign debt – considerably more than the total for 2024 - supported by inflows through Japan’s tax-advantaged investment schemes.
Falling hedging costs, helped by expected U.S. rate cuts, may encourage even more buying abroad.
Meantime, the BOJ appears poised for another policy move.
According to three government sources, the bank is planning to raise its policy rate from 0.5% to 0.75% in December, a shift Governor Kazuo Ueda hinted at earlier in the week.
Government officials have signalled they will not stand in the way of a hike, even under the dovish leadership of Prime Minister Takaichi.
In response, bond markets were quick to react, with the 10-year yield touching 1.93%.
Traders now see a strong chance of a December move.
However, the final decision will depend on upcoming wage data, the U.S. Federal Reserve’s next steps, and prevailing market conditions.
It remains unclear how far the BOJ intends to raise rates over time.
Ueda recently told the market that the bank is still unsure about Japan’s “neutral” interest rate - a level that neither stimulates nor restrains the economy; however, current BOJ estimates put that somewhere between 1% and 2.5%.
More clarity is expected after the December policy meeting, when Ueda holds his regular press conference.
