High yields attract investors ahead of Bank of Japan decision, strong demand for 2-year Japanese government bond auction

According to Zhitong Finance APP, as the market widely expects the Bank of Japan to keep rates unchanged in the interest rate decision to be announced on Friday, higher yields have attracted investors to participate, leading to strong demand in the Japanese 2-year government bond auction. It is reported that the bid-to-cover ratio for this auction was 4.03 times, the highest since June, surpassing the previous auction's 3.89 times and also above the 12-month average of 3.84. Another sign of strong investor interest is that the "tail" of this auction (the difference between the average awarded price and the lowest awarded price) was 0.014, in line with the previous month's auction.

Given that the 2-year government bond yield is more sensitive to monetary policy expectations, investors are closely watching this maturity segment. Impacted by last month's global bond sell-off, Japan's 2-year government bond yield once rose to the highest level in decades before pulling back slightly.

Ryutaro Kimura, Senior Bond Strategist at BNP Paribas Asset Management, said that ongoing concerns over French debt, coupled with uncertainties regarding the outlook for stocks related to artificial intelligence (AI), have sustained demand for safe-haven assets, which in turn supported the stable results of this auction.

He added, “On the other hand, tomorrow’s Bank of Japan meeting may revise up the assessment of underlying inflation in the statement, which could further confirm the Bank of Japan’s intention to raise rates more quickly and reach neutral rates sooner.”

Overnight index swaps show that the market currently prices in around an 84% chance of a rate hike by the Bank of Japan before the December meeting. Japan’s core inflation index for September surged to a three-year high, further supporting the case for continued rate hikes by Japanese authorities.

The Bank of Japan may maintain a relatively rapid pace of rate hikes as current price trends persist. At the same time, BOJ insiders believe the impact of hikes on the economy has so far been limited, according to informed sources. 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 future policy tightening.

Mark Cranfield, Markets Live strategist, said, “Today’s 2-year Japanese government bond auction saw strong demand, higher than the 12-month average, indicating that bond traders appear to believe the BOJ will not adjust rates on Friday. This gives investors more time to benefit from the yield curve flattening effect ahead of the December policy meeting. The weak 2-year auction in August increasingly looks like an anomaly in the JGB auction calendar.”

Meanwhile, strategists noted that Mitsubishi UFJ Financial Group—Morgan Stanley (MUFJ-MS) was the largest buyer, which is a positive signal for secondary market trading. In addition, about 61% of buyers’ identities are unknown, also suggesting that long-term portfolio investors may be providing support.

Notably, as signs of a recovery in domestic demand and a more favorable policy environment enhance the attractiveness of higher yields, global fund managers are once again showing interest in the Japanese bond market. T. Rowe Price Group Inc. had reduced its Japanese government bond exposure earlier this year, but is now favoring long-duration bonds. Allianz Global Investors is selectively adding to medium- and long-term bonds, while BNP Paribas Asset Management has established an ultra-long bond position.

This change in attitude stands in sharp contrast to earlier this year. Previously, even rising yields were not enough to dispel investors' concerns: the market worried the BOJ’s pace of rate hikes was too slow, fiscal spending was boosting bond supply, and traditional local buyers continued to wait and see. Now, expectations that the BOJ will continue hiking rates, insurance institutions re-entering the market, and fund managers’ growing confidence are empowering them to seize current high-yield opportunities.

T. Rowe Price portfolio manager Vincent Chung is currently bullish on the long end, betting on a flattening of the yield curve amid the BOJ’s hiking environment. This marks a shift from earlier this year—he bought JGBs in January (having previously underweighted the past year), but reduced exposure just a month later over rising fiscal concerns.

Vincent Chung now believes that, thanks to recent individual buying and the prospect of additional demand should proposed tax incentives be introduced, supply and demand will likely become more balanced by year-end. Potential changes to the allocation of the Government Pension Investment Fund (GPIF) could provide another source of support, though he notes any decisions would partly depend on global market performance.

Fiscal Test

Fiscal policy remains the biggest obstacle to a sustained rebound in the bond market. The fiscal 2027 bond issuance plan will test the recently revived market sentiment. Investors are closely watching how the Japanese government will raise funds for measures such as food consumption tax reductions and expanded defense spending.

Vincent Chung says his bet on curve flattening would be at risk if the budget proposal fails to clarify funding sources. Shoki Omori, Chief Japan Fixed Income Strategist at Deutsche Securities, warns that if a larger supplementary budget is introduced, or if the bond issuance plan does not further reduce ultra-long bond supply, the recent narrowing in long-end spreads may reverse.

Brandywine Global Investment Management reduced its JGB exposure earlier this year and sold its 30-year positions, but has yet to buy back in. Portfolio manager Carol Lye noted that the Sanae Takaichi Cabinet’s stance downplaying further reflation has helped stabilize yields, but investors are still waiting for a credible financing plan. With 10-year yields falling back below 3%, she also sees the possibility of demand slowing.

The BOJ will provide another test in its policy meeting on Friday. Officials are widely expected to keep rates unchanged, and investors are focused on Governor Kazuo Ueda’s guidance on the pace of tightening and how far rates are from their eventual peak.

James McAlevey, Global Head of Aggregate and Absolute Return at BNP Paribas Asset Management, believes further confidence will require a “relatively restrained fiscal response” from the government as well as continued BOJ tightening. He says the central bank does not necessarily need to raise rates this week, but action in December and continued “relatively hawkish” communication would suffice.