Japan's economic expansion decelerated in the second quarter, with annualized GDP rising just 1.1%, well below the 2.0% market consensus and the prior quarter's revised 1.9% growth. This slowdown, driven by weak capital spending and private consumption, complicates the Bank of Japan's (BOJ) policy communication as it weighs the timing of its next interest rate hike.

The GDP data, released by the Cabinet Office on Monday, showed capital investment fell 1.2% on a non-annualized basis, a sharp decline from the previous quarter's revised 1% drop and far below the expected 0.5% increase. Private consumption was flat, missing forecasts for a 0.4% rise, reflecting consumer caution amid rising living costs. This mixed result undermines the case for a September rate hike, which had been priced in with an 80% probability by markets, suggesting the BOJ may shift from a high-conviction rate path to a more data-dependent stance.

Despite the GDP weakness, the 10-year Japanese government bond yield surged to around 2.90%, its highest since September 1996. This rise indicates that the bond market is now pricing in not just BOJ rate hikes, but also inflation risks, fiscal supply concerns, and a higher term premium. The weak GDP may dampen short-term rate hike expectations, but it does not necessarily lower long-term yields, highlighting a risk of steepening amid slowing growth and hawkish policy needs.

Deepening Challenges for Japan's Economy

The slowdown comes as Japan faces headwinds from Middle East geopolitical tensions, which have pushed up fuel and oil product prices and disrupted supply chains. These factors have dampened business investment, especially among small and medium-sized enterprises, which are adopting a wait-and-see approach. The data also raises concerns for Prime Minister Sanae Takaichi, whose approval ratings have slipped as consumers grapple with higher food and utility costs. Her government has introduced subsidies to cap utility bills and plans to cut the food consumption tax to 1% for two years from April next year.

Economists note that while the GDP figures are weaker than expected, the underlying recovery trend remains intact. Employee compensation increased from the previous quarter, and real wages are growing year-on-year. However, the capital expenditure decline suggests that companies are becoming more cautious about future growth prospects, particularly in light of the energy price squeeze from the Iran conflict. The BOJ's communication will be crucial as it navigates between supporting growth and addressing inflation, with the 10-year yield near a key threshold that could trigger further selling if it reaches 3%.