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THE FORCES LETTER December 29, 2025

This Week's Focus

I read three different analyses this week of Japan's bond market selloff. One emphasized the Bank of Japan's rate hike. Another focused on the record budget announcement. A third pointed to fiscal credibility concerns. This made me think about how we identify which force actually drives outcomes when multiple pressures converge. Japan's 10-year government bond yield has climbed to around two percent, the highest level in twenty-seven years. Understanding why requires looking at how fiscal and monetary policy interact when they move in opposite directions.

When Monetary Tightening Collides with Fiscal Expansion

The Bank of Japan raised its policy rate to 0.75 percent on December 19, the highest level since 1995. The rate hike occurred days before Prime Minister Sanae Takaichi's government approved a record budget of 122.3 trillion yen for fiscal 2026, a 6.3 percent increase requiring approximately 29.6 trillion yen in new bond issuance. The government also passed a separate 21.3 trillion yen stimulus package in November.

Increased bond supply creates direct pressure on prices, which move inversely to yields. Markets must absorb more debt while the central bank steps back from its role as dominant buyer. The Bank of Japan's rate increases change the opportunity cost of holding long-term bonds. As the policy rate rises toward neutral, somewhere between one and two percent, investors demand higher yields on 10-year bonds to maintain adequate term premium.

This combination raises questions about debt sustainability that had been dormant under ultra-loose conditions. Japan's debt-to-GDP ratio stands at approximately 230 percent, the highest among major economies. Total outstanding debt is projected to reach 1,344 trillion yen by the end of fiscal 2026. For decades this remained manageable because borrowing costs stayed near zero and the Bank of Japan purchased enormous quantities of government bonds.

The shift to positive rates fundamentally alters this calculation. Debt servicing costs in the fiscal 2026 budget are projected to exceed 31 trillion yen for the first time. The Finance Ministry has raised its assumed interest rate for calculating these costs to three percent, up from two percent in fiscal 2025. Each additional percentage point increase in yields has direct fiscal consequences that compound as existing debt rolls over at higher rates.

Higher yields either force fiscal consolidation or require more bond issuance to finance the same spending plus the higher interest burden. If markets perceive the government lacks the will or capacity to consolidate, they demand an additional risk premium, pushing yields higher still. This concerns analysts who draw comparisons to the United Kingdom's bond market turmoil under Liz Truss in 2022, though Japan's circumstances differ. Japan issues debt in its own currency, maintains current account surpluses, and benefits from a large domestic investor base.

Pressure, Constraint, and Leverage

Three pressures are pushing yields higher. The Bank of Japan is reducing bond purchases while the government increases issuance. Core inflation has stayed above two percent for three years. Prime Minister Takaichi's commitment to expansionary fiscal policy creates uncertainty about whether consolidation will come before yields force it.

The constraints bind differently on each actor. The government cannot easily cut social security spending, which reached 39.1 trillion yen, or defense spending, which hit 9.04 trillion yen. The Bank of Japan must normalize policy without triggering a fiscal crisis, but third-quarter GDP contracted 2.3 percent. Private investors can demand higher yields but cannot force either the government to consolidate or the bank to ease.

The Bank of Japan holds the most leverage because it controls the policy rate. But if the government keeps expanding spending, the bank faces a choice between tolerating higher inflation or tightening so much that debt servicing becomes unsustainable. The yen's weakness adds pressure by making imports more expensive, which reinforces inflation.

Two Sources Worth Your Time

Bank of Japan December 2024 Policy Statement
https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2025/k251219a.pdf
The official statement shows why the bank judged conditions appropriate for raising rates and reveals its framework for thinking about further normalization. The board reached unanimous consensus, suggesting internal alignment that markets can use to calibrate expectations.

Bloomberg reporting on Japan's fiscal 2026 budget and market reaction
The coverage connects the budget's record size to immediate market movements and shows how the Finance Ministry's decision to raise its assumed interest rate to three percent reflects expectations about the Bank of Japan's future policy path.

One Concept Explained: The Debt Sustainability Feedback Loop

A debt sustainability feedback loop occurs when rising yields create fiscal pressures that validate or contradict the concerns that drove yields higher. When investors worry about a government's ability to service its debt, they demand higher yields. Higher yields increase borrowing costs, which worsens the fiscal position, which validates investor concerns and can drive yields even higher. This is what countries like Greece experienced during the European debt crisis.

Japan's situation is complicated. The debt-to-GDP ratio suggests extreme vulnerability, but Japan issues debt in its own currency to a primarily domestic investor base and maintains current account surpluses. These factors have historically prevented the negative loop from activating.

The question is whether the shift from negative rates to positive rates changes the equation. When the Bank of Japan was suppressing yields through bond purchases, the feedback loop could not gain momentum. With that mechanism removed, market forces can now express views about sustainability through price movements. The test will come if yields rise to levels that create genuine fiscal stress. The government must then either consolidate or pressure the Bank of Japan to halt normalization.

What I'm Watching

I will be tracking two indicators in the weeks ahead. The first is the Bank of Japan's summary of opinions from the December meeting, which should be released early in January. Any indication that members are becoming more cautious about the pace of tightening would signal that the fiscal constraint is binding more than the bank has acknowledged.

The second is the behavior of Japanese institutional investors, particularly pension funds and insurance companies. If domestic demand proves insufficient to absorb government borrowing needs without further yield increases, that would indicate the supply-demand imbalance is more severe than current pricing suggests.

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THE FORCES LETTER: December 29, 2025