Bank of Japan QT hitting the brakes? It is rumored that the next fiscal year may temporarily suspend the reduction of bond purchases, but there are still internal disagreements.

According to informed sources, the Bank of Japan is considering maintaining the current scale of government bond purchases after the next fiscal year, thereby pausing the process of reducing bond purchases. This measure will be a key turning point in its Quantitative Tightening (QT) plan. At the policy meeting held on June 15-16, the Bank of Japan will evaluate the current bond purchase reduction plan running until March next year and announce a new plan for the fiscal year 2027 and beyond. As the market generally expects no change in the existing bond purchase reduction plan, the focus for investors is whether the Bank of Japan will continue to reduce the monthly bond purchase size after fiscal year 2027 or maintain the current size of around 2.1 trillion yen (about 130 billion U.S. dollars) per month. Four sources said that given the progress made in reducing the Bank of Japan's massive balance sheet, the Bank is inclined to pause the reduction of bond purchases. One source said: "Even if the reduction of bond purchases stops, the size of bonds held by the Bank of Japan will decrease significantly merely due to natural reductions in maturing bonds." The other three sources also expressed similar views. They said that the Bank of Japan may stop the practice of annually setting a bond purchase reduction plan and instead adopt an open arrangement pledging to maintain the monthly bond purchase size at 2.1 trillion yen. In addition to the quantitative tightening decision, the market generally expects the Bank of Japan to raise the policy rate from 0.75% to 1% at the meeting next week. With the probability of a rate hike by the Bank of Japan in June already close to 90%, what investors are currently more concerned about is whether the rising inflation pressure from the U.S. and Israel's war on Iran will prompt the Bank of Japan to accelerate its future rate hike pace. Two sources said that although the Japanese financial environment remains loose, at least for now, the Bank of Japan sees no need to hasten or continuously implement rate hikes, as the impact of the Middle East war on the economy remains highly uncertain. Internal divisions However, sources said that the decision to pause the reduction of bond purchases may be a evenly matched battle within the Bank of Japan's nine-member policy board, as there are divisions within the board. Some members want to prioritize calming investor sentiment, while others believe that reducing bond purchases steadily should continue, in order to reduce the Bank of Japan's massive balance sheet. Under the leadership of Governor Haruo Ueda, the Bank of Japan has been reducing its bond holdings since 2024 as part of ending decades of ultra-low interest rate policy and normalizing monetary policy. Currently, the Bank of Japan reduces its monthly bond purchase size by 200 billion yen each quarter. Currently, the Bank of Japan still holds 49% of issued Japanese government bonds in the market, so any policy adjustment it makes will have a significant impact on bond yields and the financing costs of Japans massive debt system. Regardless of whether it continues to reduce bond purchases, the Bank of Japan's bond holdings are expected to decrease by up to 5 trillion yen annually due to maturing Japanese government bonds. In fact, since reaching a peak at the end of 2023, its bond holdings have already decreased by nearly 20%. The Bank of Japan has previously stated that its Quantitative Tightening plan aims to reduce control over yields while avoiding excessive market volatility in the bond market. However, as the Bank of Japan gradually exits the market, the bond market faces the risk of a shortage of buyers, so policy operations must remain cautious. Last week, Governor Ueda emphasized that the Bank of Japan must focus on maintaining stability in the bond market, indicating that its main focus is still on preventing sharp fluctuations in yields. Bank of Japan board member and former bond strategist Hajime Takata warned in February that reducing bond purchases could put pressure on a bond market that is already oversupplied. However, pausing the reduction of bond purchases is not set in stone, as some board members have indicated that they want to continue steadily reducing the Bank of Japan's balance sheet. This includes policy board member Naoki Tamura, who previously worked in banking. Last June, when the Bank of Japan decided to quarterly reduce its bond purchases by 2 trillion yen for the fiscal year 2026, he voted against it, advocating for a reduction of 4 trillion yen per quarter. Earlier this month, policy board member Junko Koeda said in a speech that the Bank of Japan should "steadily proceed" with balance sheet normalization, with its significant bond holdings being a "key factor" driving this process. Political resistance Furthermore, in the context of the Kishida administration advocating for tax cuts and increased spending, and relying on borrowing to raise funds, the political resistance faced by the Bank of Japan in implementing quantitative tightening will increase. With concerns about inflation, rate hikes, and the market's fears that the Japanese government will expand fiscal spending to support the economy, Japanese government bonds have experienced a sell-off. The yield on Japan's benchmark 10-year government bonds has risen from around 0.7% when the Bank of Japan began raising rates to about 2.67% currently. Akira Otani, Managing Director of Goldman Sachs Japan and former senior economist at the Bank of Japan, pointed out: "The inflation risks from the Middle East situation, combined with Japan's active fiscal policy, are pushing up bond yields. Further reducing the scale of bond purchases may raise yields and trigger political friction." Former Bank of Japan official Nobuyasu Atago said, "We see Japanese government bond yields rising quite rapidly, making it difficult for investors to buy bonds, and the Ministry of Finance may also start to feel concerned. Considering the political resistance, the Bank of Japan has no reason to continue reducing its balance sheet in the next fiscal year." He bluntly stated that regardless, what the Japanese government least wants to see is a rise in bond yields. If the yield on the 10-year Japanese government bond exceeds 3%, the Japanese government's debt servicing costs will further swell, constraining the already limited fiscal space.