Inflation shock boosts interest rate hike expectations, Japanese short-term government bond yields rise to multi-decade highs

Bloomberg News reports that as market expectations for the Bank of Japan’s recent rate hike increase, the two-year Japanese government bond yield has risen to its highest level since 1996, while the five-year yield has hit a record high. Data shows that the two-year bond yield, which is sensitive to monetary policy expectations, rose 1.5 basis points to 1.32% on Thursday, surpassing the previous high of 1.31% reached last month; the five-year yield briefly increased by 2.5 basis points to 1.74%, the highest level since the issuance of such bonds in 2000.

Earlier, following the outbreak of the Middle East war and the market digesting inflation shocks driven by oil prices, global bond markets experienced widespread sell-offs. Central banks’ warnings about ongoing price pressures pushed up short-term bond yields.

Rinto Maruyama, a foreign exchange and interest rate strategist at Sumitomo Mitsui Trust Securities, said, “This is the market pricing in a rate hike by the Bank of Japan in response to rising inflation in Japan. I believe rising oil prices have increased expectations for the terminal rate.”

Overnight index swaps show that traders estimate a 64% chance of a rate hike in April and an 89% chance in June. Rising oil prices are also pressuring the yen, which is approaching a key level of 160 yen per dollar.

Bank of Japan Governor Kazuo Ueda left the possibility of a rate hike in April open after last week’s policy meeting. Ueda stated that, although vigilance remains due to market volatility and deteriorating risk sentiment, if the underlying inflation trend persists, a rate hike cannot be ruled out even if the economy faces temporary pressures.

Meanwhile, Japan’s largest labor union, Rengo, reported that average wages have increased by more than 5% for the third consecutive year. According to preliminary statistics released by Rengo on Monday, the union’s affiliated unions have currently reached an average wage increase agreement of 5.26%. This figure is slightly lower than the 5.46% reported earlier this year, but the average base salary increase is 3.85%, slightly higher than last year’s 3.84%. Previously, workers demanded a total wage increase of 5.94%. This suggests that inflationary pressures are expected to persist, likely prompting the central bank to raise interest rates further in the coming months.

The Japanese government has pledged to provide subsidies to keep gasoline prices around 170 yen per liter and has allocated 800 billion yen from the FY2025 budget reserves. While these measures may ease household burdens, they also highlight policy trade-offs, as fiscal support could complicate the Bank of Japan’s tightening path.

Ryosuke Kimura, a senior fixed income strategist at AXA Investment Managers, said, “More and more people believe that the Sano government’s approach of subsidizing to suppress energy prices is wrong, and expectations for an early rate hike by the Bank of Japan are increasing.”