Japan's economy unexpectedly "hit the brakes"! The GDP in the second quarter grew only 1.1%, while the yield on 10-year Japanese government bonds surged to a 30-year high.

Affected by the uncertainty triggered by the geopolitical conflicts in the Middle East, Japan's capital expenditure has continued to decline. For the three months ending in June, Japan's economic growth unexpectedly slowed, a result that could complicate the Bank of Japan's policy communication as it weighs the timing of its next interest rate hike. Data released by Japan's Cabinet Office on Monday indicated that the country's real Gross Domestic Product (GDP) grew at an annualized rate of 1.1% in the second quarter. This growth rate is well below the revised 1.9% from the previous quarter and significantly less than the 2% annualized growth rate predicted by Japanese economists, yet it still marks Japan's third consecutive quarter of economic expansion. In addition, Japan's capital investment for the second quarter decreased by 1.2% on a non-annualized basis, a drop substantially larger than the revised 1% decline from the previous quarter, and clearly falling short of the market consensus forecast of a 0.5% increase. This GDP data marginally weakens the Bank of Japan's "growth permission" for an immediate hike in September, but it is not enough to overturn the trajectory of rate increases. Japan's second quarter GDP grew at an annualized rate of only 1.1%, below the market expectation of 2.0%, private consumption remained flat quarter-on-quarter, and capital expenditure declined by 1.2%, indicating that domestic demand, particularly corporate investment, is being impacted by high energy costs and the Middle East conflicts. Therefore, if the Bank of Japan solely considers the demand side, it has every reason to delay its next rate hike until October or even later. However, the issue is that the Bank of Japan is not currently facing typical demand overheating but rather a weak yen combined with the impact of imported energy shocks, rising corporate prices, and elevated inflation expectations. Earlier in August, media reports citing informed sources stated that the Bank of Japan had discussed the possibility of raising interest rates again as soon as September 17-18, and the market had previously priced in about an 80% probability of a rate hike in September. Weak GDP may shift the September rate hike from a "high certainty trade" back to a data-dependent decision. Of further concern, the yield on ten-year Japanese government bonds has recently climbed back to about 2.90%, reaching its highest level since September 1996 against the backdrop of weak GDP. This indicates that the rise in long-term interest rates is no longer merely a bet on the Bank of Japan's rate hike but also reflects the simultaneous trading of inflation risks, fiscal supply, and extreme term premiums. Naoki Hattori, chief economist at Mizuho Research Institute, remarked: "Regarding capital expenditure, our fundamental view is that investment remains robust, especially in areas like artificial intelligence and data centers. However, some small and medium-sized enterprises may have adopted a wait-and-see approach, with increasing uncertainty stemming from the tense situation in the Middle East potentially leading some companies to shelve their investment plans." Japan's economy unexpectedly "hits the brakes"! The Bank of Japan's anticipated "September rate hike" shifts from certainty to data-driven speculation. Keiji Kanda, chief economist at Daiwa Institute, stated: "Consumption is quite weak. The decline in non-durable goods was greater than expected, and considering that consumer performance was not as strong as anticipated, along with weak capital expenditure, I think the overall outcome cannot be considered particularly strong." As shown in the above image, Japan's economic growth has unexpectedly slowed amid tensions in the Middle East. With this data release, Japan's economy is facing shocks from the conflicts in the Middle East. These conflicts have pushed up fuel and oil product prices and disrupted some supply chains. This unexpected slowdown may complicate the Bank of Japan's policy communication as it weighs the timing of the next rate hike. According to the pricing in the overnight swap market as of Monday morning, interest rate futures traders believe that the chances of the Bank of Japan raising the benchmark interest rate at its next monetary policy decision on September 18 are 80%. Among other factors dragging down economic growth, private consumption remained flat quarter-on-quarter, below the market's general expectation of a 0.4% increase, while the previous quarter's private consumption was revised to 0.5% growth. This result likely reflects a weakening willingness to shop among consumers facing the rising cost of living. The signs of weak domestic demand will worry Prime Minister Sanna Maruko. About six months ago, she won an overwhelming election victory, but as consumers continue to endure pressure from rising prices of essential goods like food, her approval ratings have begun to decline. The Maruko government has introduced subsidy measures to limit the rise in utility costs and now plans to lower the food consumption tax to 1%, effective from April next year, for a period of two years. "The GDP growth rate for the second quarter is above the potential growth rate, but its specific composition weakens the Bank of Japan's rationale for a rate hike in Septemberan action that had increasingly been factored into market pricing. The decline in capital expenditure may indicate that companies are becoming more cautious about future growth prospects amid the oil price squeeze triggered by conflicts in the Middle East," said Taro Kimura, a senior economist at Bloomberg Economics. The GDP data contrasts with a series of generally optimistic corporate data from the same period. The Bank of Japan's Tankan survey showed that, driven by demand for AI computing power and infrastructure, business confidence among large manufacturers in Japan reached its highest level since 2018 in June, while confidence among large non-manufacturers in the server sector remained near its strongest levels since 1991. Since the end of the first quarter, Japan's industrial production has been growing monthly, with forecasts suggesting further increases in production in July and August; meanwhile, the manufacturing purchasing manager's index (PMI) in Japan remains high, previously reaching its highest level in 12 years in April. Despite relatively strong corporate profits, business investment continues to decline. In the three months ending in March, Japan's corporate recurring profits grew significantly above market expectations. Certainly, companies are facing higher operating costs. In July, corporate goods prices continued to rise at a high pace, increasing by 7.2% year-on-year, forcing companies to absorb pressure to pass costs on to customers and raise prices. As the Strait of Hormuz remains effectively closed, the Japanese government has been trying to ease tensions in the energy market by diversifying its energy sources. June trade data shows that crude oil supplied from the United States accounted for nearly one-third of Japan's oil imports, up from only about 7% in February. Looking ahead, Japan's economy faces both favorable and unfavorable factors. However, economists indicate that robust wage growth from annual salary negotiations and government subsidy measures are expected to continue supporting household consumption expenditure. Kanda noted: "The consumption performance is weaker than expected, but employee compensation has increased compared to the previous quarter, and real wages continue to grow year-on-year. Therefore, considering these factors, I do not believe the underlying recovery trend of the Japanese economy has been undermined." Following the data release, the yen strengthened slightly, rising from around 159.21 to 159.04. Since the governments of Japan and the United States intervened to support the yen at the end of July, the yen's rise has been somewhat limited, and it remains well below its 10-year average level of 126.09. Unexpected cooling in GDP while ten-year Japanese government bond yields surge to 30-year highs! This GDP data marginally weakens the Bank of Japan's "growth permission" for an immediate rate hike in September, but it is not sufficient to overturn the rate hike trajectory. Japan's second quarter GDP increased at an annualized rate of only 1.1%, below the market expectation of 2.0%, private consumption remained flat quarter-on-quarter, and capital expenditure unexpectedly fell by 1.2%, indicating that domestic demand, particularly corporate investment, is being impacted by high energy costs and the Middle East conflicts. Consequently, if the Bank of Japan only considers the demand side, it has good reason to postpone the next rate hike until October or even later. Nevertheless, the issue is that the Bank of Japan is currently not facing typical demand overheating but rather a weak yen and shocks from imported energy amidst geopolitical conflicts in the Middle East, along with rising corporate prices and elevated inflation expectations. The Bank of Japan has discussed the possibility of raising interest rates again as soon as September 17-18, and the market had previously priced in about an 80% probability of a rate hike in September. Weak GDP may make the September rate hike shift from a "high certainty trade" to a data-dependent decision rather than concluding the tightening cycle itself. Japan's debt market benchmark risk-free yield metricsthe yield on ten-year Japanese government bondshave once again strongly reached around 2.90% against the backdrop of weak GDP, marking the peak level since September 1996. This also indicates that the rise in long-term interest rates is no longer merely a bet on the Bank of Japan's rate hike, but also reflects a concurrent trading of inflation risks, fiscal supply, and term premiums. The expansive fiscal plans of the Maruko government, public debt exceeding 200% of GDP, energy import costs, and the Bank of Japan's continued reduction of bond purchases require investors to demand a higher term premium for holding long-term Japanese government bonds. A yield near 3% has already been viewed by some market participants as a potential trigger for a new round of selling. Weak GDP may suppress short-term rate hike expectations, but it does not necessarily lower long-term yieldsJapan is exhibiting a classic risk of "growth slowdown, ongoing hawkish policy, and fiscal and inflation premiums pushing up long-term bonds." If the September rate hike is delayed yet ten-year yields remain at elevated levels of 2.8%-3%, it would imply that market concerns have shifted from "the central bank's interest rate" to a repricing of Japan's long-term fiscal and inflation credibility.