(Sept 15): Japanese government bonds fell after the government was said to be considering a new mid-term defence spending target equivalent to 3.5% of gross domestic product, adding to fiscal concerns and outweighing support from a solid 20-year auction.

Defence officials have signalled a willingness to sharply increase defence spending in meetings with their US counterparts, according to people familiar with the matter. Bond futures extended losses after the report while the benchmark 10-year yield rose 4.5 basis points to 3.03%, its highest level since 1996.

The proposal would be a “strong selling factor” for bonds, with no funding source indicated for the additional annual spending, said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management. It also shows that Japan Prime Minister Sanae Takaichi’s expansionary fiscal stance remains unchanged, he added.

Fiscal concerns were already weighing on the bond market. Japan’s ministries have requested a record amount of spending for the next fiscal year, intensifying scrutiny over how the plans will be financed and whether additional bond issuance will be required.

The domestic pressures are being compounded by a global debt selloff. Escalating Middle East tensions pushed oil prices higher, fuelling inflation concerns and driving up borrowing costs globally. The 10-year Treasury yield breached 5% on mounting inflationary pressures as well as rising expectations of Federal Reserve tightening at its meeting this week.

The Bank of Japan is also widely expected to raise rates this week, with traders looking to Governor Kazuo Ueda’s post-decision press conference for signals on the pace and scope of further tightening.

The selloff came despite a smoothly received 20-year bond auction. The bid-to-cover ratio was 4.01, compared with 3.98 at the previous sale, and a 12-month average of 3.73. In another sign of robust investor interest, the tail, or gap between average and lowest-accepted prices, was 0.15, compared with 0.17 last month.

While the outcome of the 20-year sale was not as severe as feared, “vigilance remains necessary” given rising oil prices and the spillover of upward pressure on long-term government bond yields in the US and Europe, said Ryutaro Kimura, senior bond strategist at BNP Paribas Asset Management. “Consequently, it remains difficult to expect a sustained decline in super-long JGB yields.”

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