Analysis-Japan's fiscal woes put BOJ bond taper plans to test

By Leika Kihara

TOKYO (Reuters) -Talk of big fiscal spending and a subsequent spike in super-long yields are raising questions over just how quickly the Bank of Japan can taper its bond purchases, adding to the challenges it faces in removing remnants of its massive monetary stimulus.

While the BOJ is unlikely to ramp up bond buying, the rise in super-long yields could affect its decision on the pace and composition of future quantitative tightening (QT), say analysts and sources familiar with the central bank's thinking.

"Having ditched yield curve control last year, long-term interest rates are no longer monetary policy tools for the BOJ," one of the sources said. "The key would be whether the rise in super-long rates affects yields for other maturity zones."

Yields on super-long Japanese government bonds (JGB) have risen steadily since April even as those on other maturities remain stable, with the 40-year yield hitting a record high of 3.44% on Monday.

While the rise is driven partly by dwindling demand from life insurers, it also reflects market expectations of Japan's worsening finances as lawmakers escalate calls for huge spending and tax cuts ahead of an upper house election slated for July.

"Investors are shunning super-long bonds on worries about Japan's fiscal problems. That's eroding liquidity and causing market distortions unseen in the past," said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management.

While the BOJ's QT plan is unlikely to have a direct effect on its rate-hike path, a spike in bond yields could hurt business confidence and make it harder to convince the public of the need to push up short-term borrowing costs.

The market rout comes at a delicate time for the BOJ, which will review at next month's policy meeting an existing QT programme running through March, and come up with a bond taper plan for April 2026 onward.

Under the current plan laid out last year, the BOJ has been slowing bond purchases by around 400 billion yen ($2.74 billion) per quarter to halve monthly buying to 3 trillion yen by March 2026 - a pace that will diminish the bank's $3.9 trillion balance sheet by up to 8%.

Next week, the BOJ will conduct consultations with banks, insurers and other market participants for their views on the desirable pace of tapering. The findings will serve as a basis for the board's decision on the QT plans at the June 16-17 rate review.

NO QUICK FIX

The QT plan is a crucial part of the central bank's strategy to wean the economy off decades of ultra-loose monetary policy.

After a fairly smooth start with an end to negative rates and bond yield control last year, its policy normalisation has been disrupted by U.S. President Donald Trump's tariffs, which are expected to cause some delay in raising short-term rates from 0.5%.

Many analysts expect the central bank to make no change to its current QT plan, and roughly maintain or slightly slow the pace of tapering from fiscal 2026, to avoid upending markets.

The recent spike in super-long bond yields could draw calls from market participants for the BOJ to fine-tune the composition of the bonds it buys. It may also discourage the BOJ from pursuing a faster taper in future QT plans, analysts say.

Taking note of the "significant rise" in super-long yields, one board member said the BOJ must pay attention to liquidity conditions for each maturity at the June QT review, according to a summary of opinions at the April 30-May 1 meeting.

"The hurdle for changing the current taper size is extremely high," though the rise in super-long yields could affect discussions on future QT plans, another source said.

As with the existing QT plan, the new programme extending beyond April will seek to give markets predictability on the tapering pace, while leaving the BOJ some flexibility in adjusting purchases, the sources said.

That may prove tricky if market distortion persists, or leads to a broader bond sell-off driven by waning market trust over Japan's finances, analysts say.

Although Prime Minister Shigeru Ishiba has resisted calls to cut the consumption tax rate, he is under pressure from within his party to compile a fresh spending package - a move that will add to Japan's huge public debt.

Mari Iwashita, executive rates strategist at Nomura Securities, points to structural factors that may keep bond markets fragile, such as the BOJ's diminishing presence, waning appetite for super-long bonds and a political over-reliance on fiscal spending.

"Such structural factors are irreversible, and not something the BOJ alone can fix," she said.

($1 = 146.1700 yen)

(Reporting by Leika Kihara; additional reporting by Takahiko Wada and Kevin Buckland; Editing by Sam Holmes)