Japanese government bond yields surged to their highest level since 1998 on Monday as fixed-income markets moved aggressively to price in an imminent interest rate increase from the Bank of Japan. The benchmark 10-year yield touched 2.1 per cent in early Tokyo trading, up from 1.85 per cent at the start of April.

The sell-off in JGBs has accelerated since the International Monetary Fund urged the Bank of Japan last week to continue gradually raising its policy rate toward a neutral level. Derivative markets are now pricing in a rate hike at the BOJ's next meeting on 1 May with roughly 88 per cent probability, with a second increase expected before the end of the third quarter.

Rising energy costs have been the primary driver of persistent inflationary pressure in Japan. With the Strait of Hormuz disruptions pushing crude oil prices above $100 per barrel for an extended period, Japan's energy import bill has ballooned, feeding through to consumer prices and reinforcing expectations that the central bank can no longer defer tightening.

The yen strengthened modestly on the rate expectations, trading at 148.2 against the dollar. Japanese equity markets fell 1.3 per cent as higher borrowing costs weighed on growth-sensitive sectors. Banking stocks were the notable exception, rallying on expectations of wider net interest margins.

Analysts at Goldman Sachs warned that the pace of the bond sell-off could itself become a source of financial instability if it continues, noting that Japanese banks and insurance companies hold enormous portfolios of long-duration government debt that are now deeply underwater on a mark-to-market basis.