Japan’s worsening fiscal outlook raises risk of higher term premium

We expect Japan’s fiscal outlook to deteriorate due to weak economic growth and pressure on the government to implement fiscal stimulus. We don’t think deficit concerns drove the recent spike in ultra-long Japanese government bond (JGB) yields, but as domestic purchasers reduce their JGB holdings, long-term yields could become more sensitive to fiscal developments in the coming quarters, raising the risk of a higher term premium.

The government has little chance of meeting its long-standing target of a balanced budget in the coming years. Social security expenses, debt servicing costs, and defence spending will keep up the pressure on expenditure. And tax revenue is likely to undershoot the government’s expectations due to the weak economic growth outlook. We think the primary deficit will stay at -2% to -3% of GDP this year, largely unchanged from 2024. Furthermore, we think a discretionary fiscal expansion is now highly likely.

We aren’t worried about the recent spike at the long end of the JGB yield curve, as yields on the more liquid 10-year bonds have stayed stable. In our view, several factors unrelated to Japan’s fiscal situation caused the spike – for example, the global yield turbulence.

That said, given the changes in market structure, we see an increasing risk that fiscal concerns could push up JGB yields in the coming quarters by raising the term premium. Given the appetite of domestic banks and life insurers for JGBs is diminishing and the Bank of Japan is still gradually exiting from quantitative easing, the share of foreign investors’ transactions is rising.