This is the third time, Nomura warns: This time, the "Japanese debt storm" is different!

The storm in Japan’s government bond market is reigniting, but this time the nature is entirely different.

According to WindTrader, Nomura Securities strategist Naka Matsuzawa warned in a recent report that the third warning from bond vigilantes against Japan’s economic policy differs fundamentally from the previous two—triggered by overseas factors, with the dominant force shifting from the ultra-long end to the 10-year Japanese government bond yield, which better reflects market-neutral interest rate expectations. This means this round of selling can no longer be simply characterized as panic selling.

The 10-year breakeven inflation rate (BEI) has risen to 2.15%, and the sharp increase in inflation expectations has caused market concerns over whether the Bank of Japan can keep inflation near its 2% target. Meanwhile, expectations of Fed rate cuts have faded, political turmoil in the UK has intensified, and rising oil prices due to the US-Iran conflict, among other overseas factors, are driving foreign investors to withdraw from the Japanese bond market. These pressures cannot be resolved by Japan’s domestic policies alone.

The yen continues to weaken against the dollar to the 158.0–158.5 range, and the Japanese stock market is also facing downward pressure from the dual instability in bonds and forex markets. Matsuzawa pointed out that the boost to stock prices from re-inflation policies depends on the tolerance of bond and foreign exchange markets—yet, with bank stocks falling amid rising yields, a signal of “bad rate increases” has already been released.

Third warning, escalation in nature

Since the Sanae Takaichi government took office, bond vigilantes have issued three warnings regarding economic policy management:

The first occurred last October, shortly after the government’s inauguration,

The second in January this year, when the food tax exemption proposal surfaced,

And the third is this overseas-driven sell-off.

Nomura’s report highlights two key differences between this round and the previous two:

First, the trigger comes from overseas—rising oil prices due to the US-Iran conflict, the complete fading of Fed rate cut expectations, worsening political risks in the UK, and multiple factors pushing foreign investors to exit Japanese bonds;

Second, the dominant force in this sell-off is no longer the ultra-long end, which is more sensitive to supply and demand, but the 10-year yield—more directly reflecting market estimates of the neutral interest rate.

Matsuzawa warns that, given the recent use of foreign exchange intervention tools by Japan’s Ministry of Finance, the policy options available to stabilize the market have diminished. If the government again dismisses this turbulence as panic selling and ignores it, it would be a dangerous move.

Fiscal concerns continue to ferment

The immediate trigger for this round of Japanese bond sell-off is reports that the government is considering drafting a supplementary budget. Although the government has previously indicated it will provide energy subsidies to cope with rising oil prices, the issuance of a supplementary budget seems only a matter of time. However, Finance Minister Satsuki Katayama recently denied the need for a supplementary budget, which immediately worsened investor sentiment.

Meanwhile, discussions on the food tax exemption plan are ongoing, fueling ongoing concerns about increased issuance of Japanese government bonds. The Japan-U.S. finance ministers’ meeting failed to effectively ease market worries about fiscal expansion or the Bank of Japan lagging behind the curve, ultimately triggering capitulation selling.

Inflation expectations surge, pressure on the central bank intensifies

Nomura’s report specifically notes that the rise of the 10-year BEI to 2.15% and the sharp increase in inflation expectations pose an independent risk—markets are beginning to question whether the Bank of Japan can keep inflation at its 2% target.

This concern directly raises estimates of the neutral interest rate, exerting upward pressure on the 10-year yield.

It is worth noting that at last week’s policy meeting, the Bank of Japan held steady, citing Middle East tensions as a reason, and did not raise interest rates. The fiscal expansion pressure from energy subsidies continues to accumulate.

Matsuzawa points out that these Japan-specific factors make foreign investors cautious about increasing their holdings of Japanese bonds.

Foreign investors cautious, Japanese investors turning to

According to Nomura, citing the latest investor flow weekly data for the week of May 4, foreign investors net bought Japanese stocks and bonds that week, with net stock purchases exceeding 1 trillion yen, marking the second consecutive week of net buying. Since early April, after the initial US-Iran ceasefire agreement, foreign investment has been predominantly net buying, with a total net inflow of 1.0 trillion yen since the outbreak of the conflict.

However, foreign investors’ attitude toward Japanese bonds is noticeably more cautious, with total net purchases of only 0.9 trillion yen during the same period. Matsuzawa analyzes that concerns over fiscal expansion and the risk of the Bank of Japan lagging behind the curve are the main reasons why foreign investors are hesitant to significantly increase their holdings of Japanese bonds.

Meanwhile, domestic Japanese investors have continued to net buy foreign bonds for the second week in a row, and in larger volumes. Nomura notes that since February, the trend of Japanese investors accelerating their overseas bond sales appears to have paused, possibly expecting that a ceasefire agreement and falling oil prices will boost expectations of Fed rate cuts.

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