Will the Bank of Japan's balance sheet reduction lead to a surge in Japanese bond yields?

Zhitong Finance has learned that as the Bank of Japan plans to reduce its balance sheet and cut bond purchases, investors will face the largest issuance of Japanese sovereign bonds in at least a decade, exacerbating the predicament faced by bondholders due to rising interest rates. The Japanese Ministry of Finance typically announces the bond issuance plan for the next fiscal year starting April 1 at the end of December. According to an analysis of official data, if it remains roughly the same as this fiscal year, considering redemptions and the Bank of Japan's purchases, the supply will increase by 64%, reaching 61 trillion yen (USD 390 billion).

This is because the Bank of Japan plans to reduce its bond purchases by nearly half from July 2024 to March 2026, which will lead to a decrease of 37.6 trillion yen in the bonds it holds in the next fiscal year. This is a bad omen for Japanese bonds, as the Bank of Japan also plans to raise interest rates further at some point to control inflation, while Japanese Prime Minister Shigeru Ishiba is also seeking to support his declining approval ratings through additional spending plans in the supplementary budget.

Eiji Dohke, chief bond strategist at SBI Securities, stated, "The current pace at which the Bank of Japan is cutting bond purchases has severely impacted the supply-demand balance in the market. If the Ishiba government resorts to populist policies, its funding needs may prevent the government from issuing fewer bonds in the next fiscal year, and the Bank of Japan may have to slow down the pace of cuts."

After the Bank of Japan maintained its policy unchanged last week, Governor Kazuo Ueda indicated that policymakers would wait longer to gather more information about Japanese wages and the policies of the newly elected U.S. President Trump before deciding on interest rate hikes. As of the end of November, the Bank of Japan held more than half of the government bonds. Ueda stated in July this year that the Bank of Japan's holdings of Japanese government bonds would decrease by 7% to 8% over the next two years but would remain above the ideal level in the long term.

Not all market participants are concerned that the increase in supply will have a significant negative impact on Japanese debt. Makoto Suzuki, senior bond strategist at Okasan Securities, said that even if factors leading to lower yields emerge, their impact may be limited to preventing yields from falling excessively. He noted that the issuance of ultra-long-term bonds is expected to decline, and the market has sufficient capacity to absorb the potentially increased supply of medium- and short-term bonds.

However, concerns about a flood of bonds have intensified bearish sentiment towards Japanese government bonds. Since the beginning of this fiscal year, these securities have fallen by more than 2%, heading towards an unprecedented sixth consecutive year of losses. The latest survey by the Bank of Japan shows that financial companies and institutional investors expect the benchmark 10-year Japanese government bond yield to rise from the current level of about 1% to 1.32% by March 2026 Makoto Yamashita, chief economist of Shinkumi Federation Bank, pointed out that as the Bank of Japan reduces its purchases, "with the deterioration of the supply-demand balance in the bond market, there is a risk of rising yields"; higher yields mean that investors do not have to buy as many bonds to obtain the spread or profit from holding bonds, "leading them to reduce purchases and further intensifying the upward pressure on yields."