The 10-year bond yield has seen the largest annual increase in 31 years! Against the backdrop of intensified fiscal concerns, it may become the "grey rhinoceros" of the market in 2026.

Concerns about the fiscal situation of the Japanese government caused the yield on the benchmark 10-year Japanese government bonds to rise by over 2 basis points on Tuesday, reaching 2.077%, not far from the level of 2.1% seen on December 22, which is the highest level since February 1999. Data shows that the yield has surged by nearly 1 percentage point in 2025, marking the largest annual increase since 1994. The volatility of Japanese government bonds in 2025 was driven by the Bank of Japan reducing bond purchases, persistent high inflation, and the Japanese government implementing a large-scale fiscal stimulus plan. Since early November, concerns about Japanese Prime Minister Taro Kono's fiscal stimulus plan impacting Japan's fiscal sustainability have led to a sharp increase in long-term government bond yields, setting new historical highs consecutively. On December 16, the Japanese parliament approved a supplementary budget for the 2025 fiscal year (April 2025 to March 2026) with a fiscal expenditure scale of up to 18.3 trillion yen, claimed to be the largest post-pandemic scale. This budget, aimed at addressing rising prices and promoting economic growth, will raise 11.7 trillion yen through new government bond issuances. Last Friday, the Japanese government finalized the budget for the 2026 fiscal year at a general account total of approximately 122.3092 trillion yen, exceeding the approximately 115 trillion yen of the fiscal year 2025 and setting a new record high. Meanwhile, the Bank of Japan raised interest rates this month and hinted at further tightening of monetary policy. The minutes of the Bank of Japan meeting released on Monday showed that Bank of Japan officials believe that current real interest rates in Japan are still very low, implying the possibility of further rate hikes in the future. However, disappointment in the markets over the lack of clear guidance from the Bank of Japan on the timing of future monetary tightening led to a weakening of the yen after the central bank announced rate hikes. This, in turn, boosted expectations in the market for the Bank of Japan to raise rates to curb the depreciation of the yen. Against this backdrop, Japanese short-term government bond yields are also facing upward pressure. As of the time of writing, the two-year Japanese government bond yield sensitive to monetary policy rose by 3 basis points on Tuesday to 1.173%; this yield has risen by over 20% in the past month. Yusuke Matsuo, Senior Market Economist at Mitsubishi UFJ Securities, stated that July 2026 looks like the most likely time for the next rate hike by the Bank of Japan, but if the yen continues to weaken against the US dollar, the timing could change. He stated in a report: "Defending the yen may become a de facto priority. This could lead the Bank of Japan to consider accelerating the pace of rate hikes, so vigilance is needed." Rising Japanese government bond yields pose a global financial market "gray rhinoceros" threat? It is worth noting that the rise in Japanese bond yields is crucial for today's US and global financial markets. For years, Japan has been plagued by deflation, and since 2016, the Bank of Japan has implemented a yield control policy. Under this policy, the Bank of Japan has kept short-term borrowing rates at negative levels and aimed to keep the yield on the 10-year Japanese government bonds at zero. These low rates, combined with rates in other parts of the world significantly higher than in Japan, have prompted global investors to borrow in yen and then switch to US dollars or euros to invest in European and American stocks, bond markets, emerging markets, and so on. A challenge facing the global financial markets is that the narrowing of the yield spread between Japanese and US bonds could lead to the unwinding of yen-based arbitrage trades, prompting funds to flow back into Japan and causing pullbacks in other markets. For example, in August 2024, a significant unwinding of yen-based arbitrage trades due to the soaring Japanese government bond yields caused turmoil in the global markets. The US market is particularly vulnerable to such shocks. Japan is the largest foreign holder of US bonds. If Japanese investors decide to withdraw funds from the US bond market due to rising yields in their own country, the US bond market will lose a crucial buyer. The fluctuations in US bond yields will directly impact US stock valuations. Manish Kabra, US Stock Strategist at Industrial Bank of France, believes that "the hawkish move by the Bank of Japan poses a greater threat to the US stock market than the Federal Reserve or domestic US policies." Signs are already emerging that both the Bank of Japan and the government are concerned about the increased volatility in the bond market. Bank of Japan Governor Haruhiko Kuroda stated on December 9 that long-term bond yields are rising "relatively quickly." To avoid market turmoil, the Bank of Japan plans to slow down its exit from the bond market. Starting from the next fiscal year, the Bank of Japan will reduce the monthly bond purchase volume by 200 billion yen per quarter instead of the current reduction of 400 billion yen per quarter. Kuroda also stated that if necessary, the Bank of Japan will increase bond purchases in special circumstances to stabilize the market. In addition, Japanese authorities plan to reduce the sale of government bonds in the fiscal year 2026 that starts in April, focusing on cutting super-long-term debt. The Japanese Ministry of Finance announced on Friday that the total amount of government bonds issued to institutional investors through auctions in the fiscal year 2026 will be 168.5 trillion yen (about 1.1 trillion US dollars), reducing by 3.8 trillion yen from the initial plan in the previous fiscal year. The total sales of 20-year, 30-year, and 40-year government bonds will be reduced by 7.2 trillion yen to 17.4 trillion yen, and according to the initial budget, the issuance volume of super-long-term government bonds will be lowered to the lowest level since 2009. Meanwhile, the issuance volume of 10-year government bonds will remain unchanged, while the sales of 2-year and 5-year government bonds will increase.