Rising expectations of a Fed rate hike trigger a U.S. Treasury selloff! Japanese bonds follow suit, with the 10-year yield approaching 2.8%.

Rising expectations of a Fed rate hike trigger a U.S. Treasury selloff! Japanese bonds follow suit, with the 10-year yield approaching 2.8%. As U.S. October CPI data came in above expectations, strengthening market bets that the Federal Reserve may need to take more aggressive rate-hike action, U.S. Treasuries were sold off on Tuesday, and Japanese government bonds followed the overnight U.S. Treasury market lower on Wednesday. The benchmark 10-year JGB yield jumped 10.5 basis points to 2.795%; the 5-year yield rose 9.5 basis points to 2.195%; and the 2-year yield, which is more sensitive to monetary policy, climbed 8.5 basis points to 1.86%. Both the headline and core U.S. October CPI month-on-month readings came in above market expectations, indicating that price pressures remain elevated and reinforcing the case for the Fed to continue raising rates. Data released by the U.S. Bureau of Labor Statistics (BLS) on Tuesday showed that U.S. October CPI rose 0.4% month-on-month, above the market expectation of 0.3%, with a prior reading of 0.6%; core CPI, which excludes volatile items such as energy and food, rose 0.3% month-on-month, above the market expectation of 0.2%, with a prior reading of 0.3% (there were no year-on-year figures for October CPI and core CPI because the U.S. federal government shutdown in October last year resulted in missing CPI data). This CPI report is the last CPI data before the Fed's December 8-9 policy meeting (November CPI is scheduled for release on December 10, the day after the decision, when year-on-year figures will resume). October nonfarm payrolls released last week showed an increase of 165,000 jobs, far exceeding expectations, with the unemployment rate falling to 4.1%. Combined with the absence of any cooling in core inflation this time, market focus has shifted to whether the December rate hike will be 25 or 50 basis points. After the release of the U.S. October CPI data, the market increased its bets on Fed rate hikes. In addition to pricing in a near-100% probability of a Fed rate hike in December, the market raised its bets on a 50-basis-point hike next month and further increased wagers that the Fed will raise rates at least twice before mid-2027. The reaction in the U.S. Treasury market was particularly pronounced. After the inflation data was released, short-term U.S. Treasury yields climbed rapidly, with the 2-year U.S. Treasury yield, the most sensitive to Fed policy expectations, surging as much as 18 basis points at one point, reflecting investors reassessing the interest rate path in the coming months. Meanwhile, the 10-year U.S. Treasury yield also rose markedly, with concerns that the Fed may extend its tightening cycle reigniting. The decline in JGBs reflects the increasingly close linkages among global bond markets. The U.S. inflation data reignited concerns about further monetary policy tightening by the Fed, driving U.S. Treasury yields sharply higher and creating spillover pressure on Japanese and other Asian bond markets. Because U.S. Treasury yields are an important pricing benchmark for global financial markets, their rise tends to raise the yield requirements for bonds of other major economies, especially as global investors reassess the policy paths of major central banks. For JGBs, the impact of rising U.S. yields is not limited to short-term market sentiment. The U.S.-Japan interest rate differential is one of the important factors affecting the yen exchange rate and cross-border capital allocation. When U.S. rate expectations rise while the Bank of Japan continues to adjust monetary policy gradually, the U.S.-Japan rate differential may widen again, thereby affecting the willingness of domestic and foreign investors to allocate to yen-denominated assets. If U.S. Treasury yields continue to rise, JGBs will need to offer more attractive yields to maintain their appeal to investors to some extent. This selloff also marks a reversal in the JGB market's trajectory. In the previous few trading sessions, JGBs had continued to rebound as a sharp U.S. stock market selloff triggered safe-haven demand and prompted traders to lower their expectations for BOJ rate hikes. Kadota Shinichiro, head of Japan FX and rates strategy at Barclays, said the overall improvement in risk sentiment "shows that the market is shifting toward a reversal from the previous sharp decline in yields." He described the earlier decline in JGB yields as "somewhat excessive" and believes there is still room for yields to recover further and retrace part of the previous decline. JGBs face domestic policy pressure; fiscal and bond supply-demand factors also warrant attention In addition to spillover effects from the U.S. Treasury market, the direction of BOJ monetary policy is also an important factor determining JGB yields. The BOJ raised its policy rate to 1.25% in September and kept rates unchanged at its late-October monetary policy meeting. However, the BOJ also signaled greater attention to upside inflation risks, hinting at room for further rate hikes ahead. BOJ Governor Kazuo Ueda said the central bank will discuss interest rates at each policy meeting, including the next one in December, rather than pre-committing to a fixed pace of rate hikes. The BOJ's October "Outlook for Economic Activity and Prices" report noted that Japan's underlying inflation has roughly reached the 2% price stability target. The BOJ believes that corporate wage- and price-setting behavior and inflation expectations among households and firms are all changing gradually, and that inflation is shifting from being driven mainly by external cost shocks in the past toward a more persistent state. The BOJ said that as underlying inflation approaches the target, monetary policy needs to focus on guarding against the risk that inflation overshoots the target further. This policy signal means that the BOJ's long phase of maintaining ultra-loose monetary policy has changed. As inflation gradually stabilizes near 2%, the market is paying closer attention to the timing of future BOJ rate hikes and the terminal rate level. The minutes of the BOJ's September meeting showed that several policymakers supported continuing to raise rates, and some members even believed that if inflation exceeds expectations, the central bank may need to accelerate the pace of rate hikes. The market therefore sees another rate hike in December as an important option. The BOJ's monetary policy normalization also means the JGB market faces a pricing environment different from the past. For many years, the BOJ kept long-term borrowing costs low through large-scale bond purchases and yield curve control, keeping JGB yields at extremely low levels for a prolonged period. Now, with the policy rate rising and the BOJ gradually adjusting its bond purchase arrangements, the market needs to reassess the appropriate yield level for JGBs. Investors' expectations for future policy rates, changes in the central bank's balance sheet, and the market's judgment on long-term inflation could all drive further volatility in JGB yields. It is worth noting that the rise in JGB yields is not entirely driven by BOJ policy expectations. BOJ board member Junko Koeda previously noted that long-term interest rates are also affected by multiple factors, including inflation risk premiums, fiscal policy risks, and the supply-demand relationship for government bonds. For example, rising international crude oil prices could intensify market concerns about global inflation and push up Japanese long-term rates through linkages in global bond markets. At the same time, the scale of government bond supply, investor demand, and changes in the BOJ's holdings of government bonds will also affect the risk premium demanded by the market. The JGB market faces pressure from fiscal conditions and structural changes in long-term bond supply and demand. Japan's government debt has long been at a high level, and when the market begins to worry that the government may expand fiscal spending or increase bond issuance in the future, investors tend to demand higher yields to compensate for potential fiscal risk and duration risk. Overall, this round of JGB declines is the result of both an external rate shock and expectations of domestic monetary policy normalization. In the short term, U.S. inflation data and Fed policy signals will continue to dominate global bond market sentiment, and if U.S. Treasury yields continue to climb, they may push JGB yields further higher. Over the medium to long term, the BOJ's gradual exit from ultra-loose monetary policy, the strengthening persistence of domestic inflation, and changes in term premiums brought about by fiscal and bond supply-demand factors all mean that JGB yields may remain at higher levels than during the long period of low rates in the past.