Rate hike clouds + supply pressure! Japan's two-year government bond auction may face a cold reception.

As speculation mounts in the market that the Bank of Japan may need to raise interest rates more aggressively to curb inflation and support the yen, investors are holding their breath for Thursday's auction of Japanese two-year government bonds. This auction comes less than a week after the Bank of Japan raised its policy rate to a three-decade high. Bank of Japan Governor Kaeida Yukio's speech following the rate decision did not provide clear guidance on the timing of future monetary tightening, leading to a weakening yen and a sharp increase in bond yields. Yields on two-year government bonds, which are more sensitive to monetary policy expectations, rose to their highest level since 1996 earlier this week. Meanwhile, the 10-year breakeven inflation rate - a key indicator of market expectations for future price pressures - also rose to its highest level since 2004 this week. Katsutoshi Inadome, Senior Strategist at Mitsubishi UFJ Trust Asset Management, said, "Concerns about the Bank of Japan lagging behind the situation in terms of policy, inflation expectations, and forecasts for the neutral interest rate are rising, leading to some unease in the market regarding this auction." While the yen depreciation and rising yields have eased since Japanese officials issued verbal warnings about the exchange rate earlier this week, this auction will still be a key gauge of market views on the Bank of Japan's policy stance. Overnight index swap data shows that there is still a possibility of another rate hike by the Bank of Japan by next September. Mark Cranfield, a strategist at Markets Live, said, "The last two-year government bond auction of the year looks set to be the first issuance of bonds with yields above 1% for that tenure, but even so, it is not guaranteed to perform strongly following the Bank of Japan's rate hike last week." He added, "The Bank of Japan's journey to raising rates has been a winding one. However, Kaeida Yukio hinted last week that when the central bank tries to persuade policymakers of the rationality of another rate hike next year, they may have to go back to square one. This is why traders are currently pricing in only one 25 basis point rate hike by September 2026." Investors are also concerned about the government bond issuance plans related to the fiscal year 2026 budget, which is expected to be approved by the cabinet on Friday. Major Japanese securities dealers have indicated this month that increasing the issuance of two-year, five-year, and 10-year government bonds for the next fiscal year is acceptable, while also calling for a reduction in the issuance of super-long-term government bonds. Sources revealed that the planned increase in new bond issuances for the fiscal year starting in April will be kept within 30 trillion yen ($192 billion), higher than the initial plan of 28.6 trillion yen for this fiscal year. Den Miki, Senior Interest Rate Strategist at SMBC Nikko Securities, said, "Now is not a good time to buy." "There is a high risk of facing immediate losses after buying due to the likely increase in the issuance of two-year government bonds." The results of this auction will be announced at 12:35 PM on Thursday Tokyo time. Investors will closely watch the bid-to-cover ratio, an important indicator of demand, which was 3.53 in the previous auction in November. They will also focus on the 'tail' - the difference between the average bid price and the lowest bid price.