[Government Bonds ②] Who determines long-term interest rates?
News that “the Bank of Japan has decided to raise interest rates” and news that “long-term interest rates have risen.” Both are about interest rates, but the people deciding them are different.
The Bank of Japan’s policy interest rate reached 1.25% with the rate hike in September 2026. However, the yield on 10-year government bonds exceeds 3%. Even though they are both yen interest rates, why is there such a difference?
The answer is because the Bank of Japan determines short-term interest rates, while the market determines long-term interest rates. Once you grasp this, you can see which of your own finances are affected by interest rate news.
The Bank of Japan determines the “overnight interest rate”
The policy interest rate that the Bank of Japan decides at its Monetary Policy Meeting is the interest rate for when banks lend and borrow money from each other for just one night. Formally, it is called the “uncollateralized overnight call rate.” The Bank of Japan sets a target for this interest rate and adjusts it so that the actual interest rate reaches that level.
In other words, the only interest rate the Bank of Japan directly determines is the shortest one. It does not decide at its meetings that 10-year or 30-year interest rates will be “a certain percentage.”
Long-term interest rates are the result of buying and selling government bonds
The long-term interest rate mentioned in the news usually refers to the yield on 10-year government bonds. And once issued, government bonds are bought and sold in the market every day, and their prices fluctuate.
As we saw last time, price and yield have a seesaw relationship.
・Many people want to buy government bonds → Price rises → Yield falls
・Many people want to sell government bonds → Price falls → Yield rises
Those buying and selling include banks, insurance companies, pension funds, and overseas investors. Long-term interest rates are not determined by any one person, but are decided as a result of the transactions of these investors.
The 10-year interest rate is a “forecast of future short-term interest rates”
So, what do investors use as a basis for buying and selling? The starting point is the forecast for future short-term interest rates.
Let’s think with an example. Suppose there are two ways to invest 100 yen for two years.
・Method A: Buy a 2-year government bond and hold it for 2 years
・Method B: Buy a 1-year government bond, and buy another 1-year government bond one year later
Suppose the current 1-year interest rate is 1%, and many people expect the 1-year interest rate a year from now to be 3%.
With Method B, it becomes 100 yen × 1.01 × 1.03 = 104.03 yen.
If the yield on a 2-year government bond is 1% per year, Method A only results in 100 yen × 1.01 × 1.01 = 102.01 yen. Since no one will buy the 2-year government bond, its price will fall and its yield will rise.
How far will it rise? Until it reaches a result almost the same as Method B.
100 yen × 1.02 × 1.02 = 104.04 yen
If it is 2% per year, it becomes almost the same as Method B. The 2-year interest rate settles at the average of the “current 1-year interest rate (1%)” and the “expected 1-year interest rate one year from now (3%)”.
The 10-year interest rate follows the same logic. How will short-term interest rates move over the next 10 years? The average of those expectations forms the foundation of the 10-year interest rate.
Therefore, if the market thinks that “the Bank of Japan is likely to continue raising interest rates in the future,” long-term interest rates will rise before the Bank of Japan actually takes action.
It is not determined by expectations alone. There is a “premium”
There is one more factor. As we saw previously, the longer the time until maturity, the greater the price movement when interest rates change. Fixing money for a long period carries that much more risk.
Therefore, investors demand an additional yield for longer-term bonds. This additional amount is called the “term premium.”
Long-term interest rate = Average of expected future short-term interest rates + Term premium
The term premium increases when the future is difficult to predict.
・When the outlook for prices is uncertain
・When national debt increases and government bond issuance is likely to increase
・When major buyers of government bonds decrease
The reason long-term interest rates sometimes rise even when the Bank of Japan is not raising interest rates is because this part is moving.
In the Securities Analyst examination, the approach of explaining solely through the average of expectations is called the “Pure Expectations Hypothesis,” and the approach of adding an additional premium is called the “Liquidity Premium Hypothesis.”
Lining up interest rates by maturity reveals market expectations
Let’s look at the actual figures. These are the yields for Japanese government bonds as of October 1, 2026 (Ministry of Finance “Government Bond Interest Rate Information”).
・1 year 1.67%
・2 years 1.94%
・5 years 2.41%
・10 years 3.09%
・20 years 3.91%
・30 years 4.12%
The longer the maturity, the higher the yield. Connecting the yields for each maturity with a line is called a “yield curve,” and the upward-sloping shape is called a “normal yield curve.”
It is also noteworthy that the 1-year yield is already higher than the policy interest rate of 1.25%. This can be read as an indication that the market is anticipating future interest rate hikes.
Conversely, there are times when long-term interest rates become lower than short-term interest rates. This is an “inverted yield curve.” It occurs when the market expects that “interest rates will fall in the future.” Since interest rates often fall when the economy worsens and rate cuts are implemented, an inverted yield curve is watched as a sign of an economic recession.
Can the Bank of Japan not move long-term interest rates?
There is a way to move them. It is to buy government bonds in large quantities. If buying increases, prices rise and yields fall.
In fact, from September 2016 to March 2024, the Bank of Japan implemented a policy to keep the 10-year government bond yield at around 0%. This is “Yield Curve Control (YCC).”
This policy has ended, and since then, the Bank of Japan has also been gradually reducing the amount of government bonds it purchases. Current long-term interest rates now reflect market views more directly than before.
What changes when long-term interest rates rise?
・Fixed interest rates for housing loans rise (variable interest rates are linked to short-term interest rates)
・The cost for companies to raise funds through corporate bonds or long-term borrowing increases
・The interest the government pays on newly issued government bonds increases
・Downward pressure is placed on stock prices (because the interest rate used to discount future profits rises)
“The Bank of Japan raising rates” refers to short-term interest rates, while “long-term interest rates rising” refers to the market. Once you can distinguish between these, your way of reading interest rate news will change.
The previous article can be found here.
Practice Problems
(a) Which does the Bank of Japan decide directly at its Monetary Policy Meeting: short-term interest rates or long-term interest rates?
(b) The current 1-year interest rate is 2%, and the 1-year interest rate one year from now is expected to be 4%. Assuming there is no risk premium, what will the 2-year interest rate be approximately?
(c) What is a state where long-term interest rates are lower than short-term interest rates called? Under what market expectation for future interest rates does this occur?
Think about it, then scroll down.
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(a) Short-term interest rates. It sets the target for the interest rate when banks lend and borrow money from each other overnight.
(b) Approximately 3%. It is the average of 2% and 4%. 100 yen × 1.02 × 1.04 = 106.08 yen, and 100 yen × 1.03 × 1.03 = 106.09 yen are roughly the same.
(c) An inverted yield curve. It occurs when the market expects that “interest rates will fall in the future.”
Summary
・The Bank of Japan decides the overnight interest rate (policy interest rate). Long-term interest rates are determined by the buying and selling of government bonds
・Long-term interest rate = Average of expected future short-term interest rates + term premium
・The yield curve, which plots yields by maturity, reflects market expectations
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