Japan's central bank raises interest rate to 1.25%, highest in 31 years

Japan's decision to increase its defense spending has sent shockwaves through global financial markets, raising concerns about fiscal discipline and sending sovereign bond yields to multi-year highs. The country's 10-year bond yield reached a staggering 3.03%, the highest level in over three decades, while 30-year bond yields approached a 30-year high of 4.1%. Speculation is growing that Japan may boost its military spending to 3.5% of its gross domestic product from the current 2%.

The Bank of Japan is expected to raise interest rates by 25 basis points on Friday, which could further fuel bond yield gains. This turmoil in Japanese bonds could have a ripple effect, spilling over into long-end debt markets in the US and Europe, already dealing with elevated yields. Investors who own equities and risk assets are likely to be deterred, as rising bond yields increase the risk premium demanded by investors.

The rising bond yields have shifted the investment calculus, with Gary Dugan, CEO of The Global CIO Office, stating that bonds are now real competitors for capital, rather than just portfolio insurance. This shift in the investment landscape has also impacted China's financial markets, with the yield on the 10-year government bond trading close to a one-year low of 1.7%.

Japan's budget request for the 2027 financial year stands at 143.1 trillion yen, a 16% increase from the previous year. While Prime Minister Sanae Takaichi has pledged to limit bond issuance, concerns persist among investors about Tokyo's unbridled spending. Japan's government debt now stands at 230% of its GDP, the highest among developed nations, as a result of heavy borrowing to combat decades of deflation.

The US Federal Reserve's decision to raise the benchmark interest rate for the first time in three years has further pressured global risk assets, including stocks and commodities. The 10-year US Treasury yield surpassed 5% for the first time since 2023, while the 30-year Treasury yield reached a near two-decade high of 5.4%. The Bank of Japan is also expected to follow the Fed's lead with a quarter-point rate increase, which could further entrench elevated sovereign yields in Japan.

Investors are closely watching Japan, with some expecting between three and four rate increases in the coming year to fight inflation and support the yen. However, a further rise in Japanese bond yields could dampen the appetite for risk assets, as the higher global discount rate and intensified competition for capital take hold.