Japan’s Yield Curve: Fiscal Risks, Market Opportunity?

Japan’s Awakened Bond Market?

• For decades, Japan’s sovereign bond market was defined by zero rates, subdued inflation and yield curve control (YCC). This era is now firmly over, with yield curves experiencing increasing stress, a stark contrast to the stability policymakers once sought. In this Cordoba note, we analyse how Japan’s macroeconomic changes have reflected on its yield curve, and how this is becoming an opportunity many investors are eyeing.

Macroeconomic Background

• Historically, Japan’s economic structure was influenced by its post-1990s legacy with low growth and recurring deflation. This led to the Bank of Japan (BOJ) deploying unprecedented measures including zero and negative interest rates, quantitative easing, and YCC to cap the 10-year yield around 0%.

• This policy regime collapsed after the inflation shock in 2021-2023. In spring 2024, YCC and negative rates were replaced with a cautious tightening scheme. The current interest rate is sitting at 0.5%, following a 25bps hike in January 2025. Following today’s meeting, policy rates were unchanged but 2 dissenter votes have raised market expectations of a future hike.

• The disinflation trend has been strong in 2025. Headline CPI slowed to 3.1% y/y in August from 3.3% in July, supported by cheaper oil and a stronger yen lowering input costs (as reflected by the PPI).

• Japan’s labour market remains tight with unemployment at 2.3% and a jobs-to-applicants ratio above 1.3. Wage settlements are above 5%, the largest rise since the 1990s. Despite this, economic growth is slow due to US tariffs of 25% on autos (around 30% of Japan’s exports to the US), thus reducing GDP forecasts.

• Fiscal spending is becoming a concern. Japan’s gross debt is 260% of GDP. With an ageing population (median age 49), rising spending on social security, pensions, and  also defence, bond issuance is heavy. The Ministry of Finance is under pressure to fund more debt at a time when the BOJ is no longer absorbing supply.

A Steep Curve: Why Yields are Rising

• Japan’s yield curve has steepened to levels not seen in decades with the 30Y JGB at 3.2%, while the 10Y sits at around 1.5%, producing one of the steepest curves in developed markets.

• Normally curves steepen when central banks cut rates as expectations of future growth and inflation rise. By contrast, Japan’s steepening is bearish. Short term yields are pinned by the low policy rate, while the long end is pricing in fiscal and inflation risk.

• Since the end of YCC, long-term bonds are trading on market fundamentals. That has exposed JGBs to global shocks: the recent sell-off in US Treasuries (30y reaching 5%), UK gilts, and long-dated European bonds has spilled directly into Japan, with investors demanding a higher confidence premium.

• Equally, political pressures have furthered this. PM Ishiba’s resignation and the upcoming LDP leadership is raising fears of further fiscal concession risk, furthering pressure on the long end. Moreover, the recent surge in corporate debt issuance has diverted demand from its sovereign market.

Cordoba’s View

Recent bond auctions suggest first signs of yields stabilising. Japan’s 20Y bond auction on September the 17th drew the strongest demand since 2020, leading to the yield dropping to 2.63%, and results showed the bid-to-cover ratio (total amount of bids relative to securities offered) increased to 4. This is a vast improvement from the failed auction in May. Hence, we believe investor appetite for duration is returning. Our positioning favours a curve flattener strategy: 

• Long 20-30y JGBs (Overweight): At decade highs, long yields look stretched relative to disinflation momentum and BOJ caution. Domestic pensions may re-enter at these levels, furthering the bullish movement.
  
• Short 2-5y JGBs (Underweight): Short maturities remain exposed to another BOJ hike given the 2 dissenting votes in today’s meeting, with markets pricing a ~60% chance of a move this year. This anchors the front end higher.

This strategy benefits from roll-down on the steep curve and hedges downside: if the BOJ prioritises growth and avoids further monetary policy tightening, long bonds should rally, offsetting short-end risk.

Key Risks We Are Watching

• US tariffs continue to hit core exporting industries such as autos and steel, suppressing growth and creating uncertainty for Japan’s trade balance.
• The Yen has rebounded since the US rate cut, but volatility remains high given recent bond market shifts.
• Weak fiscal outlook and auction demand could add long end pressure. Hence, LDP leadership spending patterns will need to be monitored.

Japan’s bond market is no longer just a funding vehicle for cheap yen to carry into higher-yielding assets abroad. Inflation risks, fiscal policy, and political uncertainty are being priced directly into the curve. The next 3-6 months will hinge mostly on two decisions: whether the BOJ delivers another rate hike, nudging the front end higher, and whether political transition signals fiscal discipline or renewed expansion. Together, these actions will determine whether the steep curve begins to flatten or entrenches further volatility.