Market turbulence is strengthening arguments for Japan’s central bank to halt the reduction of its enormous bond portfolio in the upcoming fiscal year, potentially providing breathing room for Prime Minister Sanae Takaichi as investors grow increasingly worried about her fiscal policies.
Such a halt would represent a significant shift in the Bank of Japan’s quantitative tightening strategy, which has been underway since 2024 as part of Governor Kazuo Ueda’s campaign to reverse a decade of extensive economic stimulus measures.
During its June 15-16 session, the BOJ will examine its current bond reduction schedule that runs until March and establish a new framework for fiscal 2027.
While no modifications are anticipated for the existing reduction plan, financial markets are closely watching whether the BOJ will continue decreasing its monthly bond acquisitions in fiscal 2027 or keep the current purchasing level unchanged.
Though the BOJ has not reached internal agreement on the ultimate choice, halting the reduction is gaining favor as the preferred approach, with uncertainty surrounding the Iran conflict keeping bond markets unstable, according to two sources with knowledge of the discussions.
“Markets remain volatile, so there’s no need to rush,” one source commented regarding the BOJ’s reduction plan, noting that many market participants seemed to support maintaining current purchasing levels.
Political factors may also encourage the BOJ to pause, as climbing bond yields could limit Takaichi’s spending initiatives.
“What the administration wants to avoid most is rises in bond yields,” stated one of the sources.
Recent central bank research revealed that some investors are now urging the BOJ to suspend its bond reduction strategy, underscoring the difficulties it encounters in decreasing its substantial Japanese government bond holdings.
Previous indicators suggested the BOJ might contemplate slowing its reduction plan given market uncertainty.
A more definitive signal regarding the BOJ’s bond strategy will emerge next week when the central bank publishes notes from its May 21-22 meeting with bond market participants.
“We’ve seen a pretty fast rise in bond yields, which makes it hard for investors to buy bonds. The finance ministry may be getting worried too,” explained former BOJ official Nobuyasu Atago.
“Given the political headwinds, I see no reason for the BOJ to keep tapering next fiscal year,” he added.
Worries about Japan’s deteriorating fiscal situation and increasing inflation drove the 10-year JGB yield to a three-decade peak of 2.8% last week, approaching the 3% projection the finance ministry used when preparing its fiscal 2026 budget. Exceeding 3% would increase debt servicing expenses and limit resources for additional spending.
The BOJ’s interest rate decision could also influence its reduction plan, with an increase in short-term rates to 1% from 0.75% viewed as highly likely at the June meeting.
Although the central bank has stated its reduction program carries no monetary policy consequences, the argument for slowing quantitative tightening grows stronger if it implements a rate increase, analysts note.
“With the bond market so unstable, it would be natural for the BOJ to play it safe and avoid causing undue market turbulence,” said Mari Iwashita, executive rates strategist at Nomura Securities, who anticipates a reduction pause in fiscal 2027.
“A combination of a taper pause and rate hike would be a good one,” she explained, as the former would reduce upward pressure on yields while the latter would address concerns that the BOJ is falling behind in managing inflation risks.
Increasing debt and unstable yields have intensified challenges for central banks unwinding balance sheets that expanded dramatically from years of extensive asset purchases designed to stimulate their economies.
In the United States, analysts question whether new Federal Reserve chief Kevin Warsh can advance his proposals for a smaller balance sheet as U.S. Treasuries lose appeal.
The BOJ has also proceeded carefully with its quantitative tightening program that started in 2024, gradually reducing purchases and currently cutting monthly buying by 200 billion yen each quarter.
Political obstacles for the BOJ’s quantitative tightening have increased under Takaichi, who has promised to reduce taxes and increase spending through debt-financed funding.
Regardless of reduction decisions, a decrease in the BOJ’s holdings, currently around 500 trillion yen, will continue steadily due to maturing JGBs rolling off, which has already reduced its balance sheet by 20% from its late 2023 peak.
This provides additional justification for the BOJ to maintain current purchasing levels, said former BOJ executive Akira Otani, currently managing director at Goldman Sachs Japan.
“When inflationary risks from the Middle East conflict and the government’s proactive fiscal policy are putting upward pressure on bond yields, proceeding with further tapering could cause political friction by pushing up yields,” he stated.
