Ahead of BOJ Decision, High Yields Attract Active Investor Participation; 2-Year JGB Auction Sees Strong Demand

As the market widely expects the Bank of Japan to keep interest rates unchanged when it announces its rate decision on Friday, higher yields have attracted investors, and demand at the Japanese 2-year government bond auction was strong. The bid-to-cover ratio for this auction was 4.03 times, the highest since June, above 3.89 times in the previous auction and above the 12-month average of 3.84 times. Another sign of strong investor interest was that the auction's "tail" the gap between the average accepted price and the lowest accepted price was 0.014, unchanged from last month's auction. Given that 2-year government bond yields are relatively sensitive to monetary policy expectations, investors are closely watching this maturity. Affected by last month's global bond selloff, Japanese 2-year government bond yields briefly rose to their highest level in decades before slightly retreating. Ryutaro Kimura, senior bond strategist at BNP Paribas Asset Management, said persistent concerns over France's debt problems, plus uncertainty over the outlook for artificial intelligence (AI)-related stocks, have kept demand for safe-haven assets alive, supporting the stable outcome of this auction. He added: "On the other hand, tomorrow's BOJ meeting may raise its assessment of underlying inflation in its statement, which could further confirm the BOJ's stance that it wants to raise rates faster and reach the neutral rate level as soon as possible." Overnight index swaps show the market is currently pricing about an 84% probability that the BOJ will raise rates before its December meeting. Japan's underlying inflation gauge surged to a three-year high in September, further supporting the case for the authorities to continue raising rates. The BOJ may maintain a relatively fast pace of rate hikes because current price trends remain so, while the BOJ internally believes that the impact of rate hikes on the economy has so far remained limited, according to people familiar with the matter. Traders will closely watch BOJ Governor Kazuo Ueda's press conference on Friday after the rate decision for signals on the pace and scope of further tightening in the future. Markets Live strategist Mark Cranfield said: "Demand at today's 2-year JGB auction was strong, above the average of the past year, suggesting bond traders seem confident that the BOJ will not adjust rates on Friday. This gives investors more time to continue enjoying the effect of a lower yield curve before the December monetary policy meeting. The weak 2-year bond auction in August looks increasingly like an anomaly in the JGB auction calendar." Meanwhile, the strategist noted that MUFG-MS was the largest buyer, a positive signal for secondary market trading. In addition, about 61% of buyers were unidentified, also suggesting long-term portfolio investors may be providing support. It is worth noting that global fund managers are once again showing interest in the Japanese bond market, as signs of recovering domestic demand and a more favorable policy environment have enhanced the appeal of high yields. T. Rowe Price Group Inc. cut its Japanese government bond exposure earlier this year and now favors long-duration bonds. Allianz Global Investors is selectively adding medium- and long-term bonds, while BNP Paribas Asset Management has built ultra-long bond exposure. This shift in attitude contrasts sharply with earlier this year. Previously, even rising yields were not enough to dispel investor concerns: the market worried that the BOJ was raising rates too slowly, fiscal spending was increasing government bond supply, and traditional domestic buyers remained on the sidelines. Now, the market expects the BOJ to continue raising rates, insurance institutions are re-entering the bond market, and fund managers are more confident in capturing current high-yield opportunities. T. Rowe Price portfolio manager Vincent Chung is currently bullish on the long end of the curve, betting that the yield curve will flatten in a BOJ rate-hiking environment. This marks a shift from earlier this year when he bought JGBs in January (after being underweight for the previous year), only to cut exposure a month later as fiscal concerns intensified. Vincent Chung now believes that, thanks to recent retail buying and the prospect of additional demand if proposed tax incentives are introduced, supply and demand will become more balanced by year-end. Potential changes in allocations by the Government Pension Investment Fund (GPIF) could provide another source of support, though he said any decision would depend partly on global market performance. Fiscal Test Fiscal policy remains the biggest obstacle to a further sustained bond market rebound, and the government bond issuance plan for fiscal 2027 will test the recently revived bond market sentiment. Investors are closely watching how the Japanese government will raise funds for cuts to the food consumption tax and expanded defense spending. Vincent Chung said that if the budget plan cannot clearly identify funding sources, his curve-flattening thesis would be at risk. Shoki Omori, chief Japan fixed income strategist at Deutsche Securities, warned that if a larger supplementary budget is introduced, or if the issuance plan fails to further reduce ultra-long government bond supply, the recent narrowing of long-bond spreads may reverse. Brandywine Global Investment Management cut its Japanese government bond exposure earlier this year and sold its 30-year holdings, and has not yet bought back. Portfolio manager Carol Lye said the Sanae Takaichi cabinet's downplaying of reflation rhetoric has helped stabilize yields, but investors are still waiting for a credible funding plan. With the 10-year yield falling back below 3%, she also sees the possibility that demand may slow. The BOJ will provide another test at Friday's policy meeting. Officials are widely expected to keep rates unchanged, and investors will focus on Governor Kazuo Ueda's guidance on the pace of tightening and how far rates are from their eventual peak. James McAlevey, head of global aggregate and absolute return at BNP Paribas Asset Management, believes that further confidence-building requires a "relatively restrained fiscal response" from the government and continued BOJ tightening. He said the central bank does not necessarily need to raise rates this week, but a December move and continued "relatively hawkish" communication would be enough.