Japan's economy slowed in the second quarter and missed market forecasts on softer household and business spending, highlighting the fragile nature of its recovery as the Middle East war clouds the outlook.
However, long-term bond yields hit a three-decade high as investors brushed aside the soft reading as reflecting one-off factors, and focused more on mounting inflationary risks that could prod the Bank of Japan to raise interest rates next month.
Gross domestic product rose 1.1% in annualised terms, government data showed on Monday, missing a median market estimate of 2.0% in a Reuters poll and below a revised 1.9% expansion in the previous quarter.
While the data revealed some temporary soft patches in demand, analysts say robust underlying momentum and persistent price pressures are likely to keep the case for imminent interest rate hikes intact.
"Today's GDP data was a bit weak but the economy is likely to continue recovering moderately," said Naoki Hattori, chief Japan economist at Mizuho Research Institute. "Given risks of underlying inflation overshooting its target, the BoJ is likely to proceed with a rate hike next month."
Sources have told Reuters the BoJ is set to raise rates as soon as September and is considering hiking more aggressively thereafter to avoid being behind the curve on inflation.
The benchmark 10-year Japanese government bond (JGB) yield rose for a sixth straight session on Monday to hit a 30-year high of 2.925%, as investors continued to price in BoJ rate hikes sooner and faster than earlier expected.
Private consumption was the biggest disappointment in the GDP data, falling 0.02% versus market expectations for a 0.5% increase, the first drop in eight quarters.
Analysts said the weakness was due in part to lower school fees households paid thanks to subsidies, which pushed down headline private consumption but lifted government spending.
Capital spending, a key driver of private demand, fell 1.2% in the second quarter, confounding market forecasts for a 0.4% increase. However, capital expenditure, as well as overall preliminary GDP, tend to be revised higher with updated figures.
Exports remained resilient thanks to solid US demand for Japanese hybrid vehicles and sustained global investment in artificial intelligence that supported shipments of semiconductor-related equipment and components.
Net external demand, or exports minus imports, added 0.5 percentage point to growth, largely because imports fell sharply after temporary disruptions to crude oil shipments through the Strait of Hormuz.
"I don't think the BoJ would be too worried about today's GDP data as the economy is showing remarkable resilience to headwinds from the Iran war," said Yoshiki Shinke, senior executive economist at Daiichi Life Research Institute.
The government maintained its sanguine view on the economy.
"The economy remains on a moderate recovery path, with export-driven growth offsetting weakness in domestic demand," Economy Minister Minoru Kiuchi said in a statement.
Looking ahead, analysts cautioned that rising import costs and mounting upstream price pressures could eventually feed through to consumers, posing a risk to spending later this year.
Aside from rising fuel costs from the Middle East conflict, a weak yen has lifted import prices and broader cost-of-living for households, posing a headache for policymakers.
Such price pressures have led to a flurry of hawkish comments from BoJ policymakers that bolstered the case for an early rate hike.
The government has sought to cushion the blow to households from rising living costs with subsidies, though rising bond yields may prevent it from ramping up fiscal spending any further, some analysts say.
That spells trouble for consumption, which is mostly holding up so far as a tight job market prods firms to offer higher pay.
"Government subsidies have helped contain consumer inflation so far, but a weaker yen and higher crude oil import costs raise the likelihood of broader price hikes from the autumn onward," said Takeshi Minami, chief economist at Norinchukin Research Institute.A survey this month by the Japan Center for Economic Research showed 37 economists forecast annualised GDP growth to slow to an average 0.05% in the July-September quarter.
