Japan's two-year government bond auction saw tepid demand on Friday as growing expectations of a Bank of Japan (BOJ) rate hike dampened investor appetite. The bid-to-cover ratio stood at 3.53x, below both October's 4.35x and the 12-month average of 3.66x. Another bearish signal emerged as the tail spread (difference between average and lowest accepted prices) widened to 0.012 from just 0.002 in the previous auction.

The lackluster auction pushed two-year JGB yields up to 0.977%, their highest level since 2008. Market participants are increasingly pricing in a December BOJ move, with overnight index swaps now reflecting a 57% probability of tightening next month - a sharp jump from 32% two weeks ago. The USD/JPY pair traded at 156.42 at press time amid persistent yen weakness.

While short-dated JGBs face pressure, two-year notes retain relative support due to overseas demand and their role as BOJ collateral, maintaining tight supply-demand dynamics.

Fresh economic data on Friday bolstered the case for policy normalization. Tokyo's core CPI (ex-fresh food) held steady at 2.8% year-on-year in November, slightly above forecasts. Industrial output surprised with 1.4% monthly growth in October versus expectations of a 0.6% decline. Early signals from 2026 wage negotiations also support tightening, with Japan's largest labor group Rengo targeting ≥5% pay hikes - matching this year's historic settlement.

BOJ officials have dropped increasing hints about imminent action. Former monetary policy chief Kazuo Momma noted this week that yen weakness raises December hike odds, stating "there's no need to wait for stronger wage/price signals." Political resistance to tightening appears to be easing, with Prime Minister Sanae Takaichi likely to permit rate hikes to combat inflation.

Investor caution persists ahead of BOJ Governor Kazuo Ueda's upcoming speech in Nagoya next week, which may offer clues on the policy path. Markets remain wary of Japan's fiscal health after reports showed a potential ¥18.3 trillion supplementary budget for FY2025, requiring ¥11.7 trillion in new debt issuance - a 75% increase from last year's stimulus package.

Dealers have requested increased issuance in 2-10 year JGBs while cutting super-long bonds, reflecting concerns about Japan's long-term fiscal sustainability under the Takaichi administration. "Investors are adopting wait-and-see mode pending the finance ministry's revised issuance plan," noted MUFG Morgan Stanley strategist Kazuya Fujiwara.