Japan's two-year government bond auction hits a nine-month high, with yields approaching 2008 levels attracting capital inflow

According to the Zhitong Finance APP, the results of Japan's two-year government bond auction held on Tuesday have attracted market attention. This auction set the highest demand level since October last year, with investor participation significantly increasing against the backdrop of short-term bond yields approaching highs not seen since the 2008 global financial crisis.

Data shows that the average bid-to-cover ratio for this auction reached 4.47 times, which is not only higher than last month's 3.90 times but also exceeds the average level of 3.99 times over the past 12 months. Another indicator reflecting demand strength, the tail price gap (the difference between the winning bid price and the lowest accepted price), narrowed to 0.005, a significant improvement from the previous auction's 0.012.

The secondary market reacted immediately, with two-year government bond prices rising in response, and yields slightly falling by two basis points to 0.82%. Although the yield adjustment was limited, it contrasts with the overall upward trend in recent short-term and long-term bond yields.

It is noteworthy that this auction coincided with the upcoming policy meeting of the Bank of Japan, which is expected to maintain the benchmark interest rate at 0.5% during the meeting from Wednesday to Thursday. However, according to informed sources, central bank officials believe there is a possibility of another rate hike within the year.

Takahiro Fujiwara, Chief Fund Manager at Resona Asset Management, pointed out: "The results of the two-year government bond auction reflect that the market has priced in expectations for a rate hike by the Bank of Japan quite fully. The current yield level reflects both expectations for policy tightening and provides a reasonable return space for holding the bond." However, he also emphasized that strong auction demand may not reverse the overall upward trend in yields.

Market pricing shows that the "risk-neutral yield," used to measure expectations for future short-term interest rates, has risen to 0.7%, reaching a nearly four-month high. This movement corresponds with expectations reflected in the overnight index swap market, where traders expect the probability of a rate hike by the Bank of Japan before the end of the year has risen from 57% at the beginning of this month to about 75%. The trade agreement reached between Japan and the United States has become a key catalyst, as the agreement keeps tariff levels below the market's worried 15% range, somewhat eliminating the uncertainty in the Bank of Japan's decision-making.

Currently, the market still has two major concerns: first, the balance the Bank of Japan must strike between controlling inflation and promoting economic growth; second, the impact of political changes on fiscal policy. Prime Minister Shigeru Ishiba's governance prospects are facing challenges after the ruling coalition lost its majority in the House of Councillors elections.

The market worries that if the government shifts to a more expansionary fiscal policy (such as increasing spending or cutting taxes), it may exacerbate long-term debt supply pressure, thereby pushing up long-term government bond yields. However, Shigeru Ishiba has always been known for strict fiscal discipline, and his policy inclination is seen as relatively friendly to the bond market.

Overall, the results of this two-year government bond auction not only validate the market's expectations for monetary policy normalization but also reflect investors' allocation demand during the short-term interest rate upcycle Despite ongoing political uncertainty, the implementation of trade agreements and the gradual clarification of central bank interest rate hike expectations are driving the Japanese bond market into a new pricing phase