Analysts say the tools available to calm markets - sporadic cuts ‌to bond issuance or emergency central bank buying - amount to little more than temporary patches for a bond market being squeezed by stubborn inflation and an increasingly loose fiscal stance.

"Japan hasn't experienced such sticky price pressures since the previous oil shock," said Mari Iwashita, executive rates strategist at Nomura Securities. "The challenge of anchoring inflation at the BOJ's 2% target is becoming bigger."

The global bond selloff has found its epicentre in Japan with the benchmark 10-year ​yield on the brink of hitting 3% for the first time since the mid-1990s, as investors grow increasingly nervous about the country's towering debt pile and inflation risks stemming ​from the Middle East war.

After hitting a three-decade high of 2.945% on Tuesday, the 10-year yield slid to around 2.89% on Wednesday.

Although government subsidies ⁠have kept core inflation below its 2% target, the Bank of Japan has warned of the risk of an inflation overshoot that could warrant an early rate hike.

The prospect of sooner and ​faster rate hikes has reduced concerns that the BOJ is falling behind the inflation curve. But it has also fuelled a repricing across bond markets, with investors now seeing a realistic path toward ​rates reaching 2%, well above earlier expectations for a peak near 1.5%, analysts say.

STAKES RUN HIGH

The surge in yields is emerging as a critical test for Takaichi's economic strategy.

Her case for increased spending rests on the assumption that economic growth will outpace long-term borrowing costs, allowing Japan to sustain its enormous debt burden without jeopardising fiscal stability.

That premise would come under doubt if the 10-year Japanese government bond (JGB) yield exceeds 3% with inflation running ​at 2% and real growth seen hovering around 1% at best.

In estimates released in July, the government expects real gross domestic product (GDP) growth of 0.9% in the current fiscal year ending March ​2027 followed by 1.1% the next year.

Higher yields would also threaten the affordability of Takaichi's flagship growth initiatives. At the same time, conservatives within the ruling party are pressing her to curb spending.

A sustained move above ‌3%, the ⁠very level the government used as its budget assumption, would send debt-financing costs surging past the 31 trillion yen ($195 billion) currently set aside, while simultaneously undercutting Takaichi's signature push to pour investment into growth sectors.

Under the ministry's baseline estimate assuming the 10-year yield will climb to 3.6% in fiscal 2029, debt-servicing costs will rise to 41 trillion yen that year.

Making matters tougher, the government has ruled out spending caps on requests for strategic growth sectors in next year's budget, a move that could force more debt issuance on top of revenue already lost to a planned food levy ​cut.

GOVERNMENT APPROACH KEY

As bond jitters persist, markets are ​increasingly focussed on whether policymakers have credible ⁠options to contain the selloff.

For one, the finance ministry could make ad hoc cuts to bond issuance or heed concern on over-supply in a regular meeting with investors slated for next month, analysts say.

"An adjustment to bond issuance at an irregular timing could help curb yield rises," as ​well as any sign the ministry could contemplate cuts to 10-year bond issuance, said Ataru Okumura, chief rates strategist at SMBC Nikko Securities.

Another ​option is for the BOJ ⁠to ramp up bond-buying in emergency market operations, a tool it has kept in reserve even while tapering purchases, meant for sharp, disorderly yield spikes that threaten financial stability.

While the BOJ won't rule out the step entirely, it likely sees little need to step in now with recent yield rises driven by fundamentals, said a source familiar with its thinking.

Many analysts argue yields will remain under upward pressure ⁠unless the government ​rethinks its reliance on subsidies and tax cuts to ease cost-of-living pain, an expansionary approach that only fuels demand ​and inflation.

"The BOJ can't anchor inflation expectations if the government is ramping up fiscal spending and adding to price pressures from the Middle East war," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.

"Inflation has now ​become the key risk for anyone trading JGBs," she said. "At the heart of the problem are market doubts over the government's resolve to combat inflation."

($1 = 159.3200 yen)