Japanese voters and the bond market—Sanae Takaichi can only choose one!

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Japanese Prime Minister Sanae Takaichi is facing the most difficult dilemma of her political career: whether to please voters to win the snap election on February 8, or to tighten fiscal policy to calm increasingly turbulent bond markets. As Takaichi tries to fulfill her promise of "responsible fiscal expansion" through tax cuts and stimulus spending, Japan's government bond market is sending strong warning signals. This game not only concerns Japan's economic outlook, but may also trigger a chain reaction in global financial markets.

According to the Financial Times, in order to win voter support in the election, Takaichi this week promised to suspend the food consumption tax for two years, a measure expected to cost about 5 trillion yen (around $32 billion). This move, which breaks expectations for fiscal discipline, has quickly sparked market panic. Not only did it fail to establish voter confidence, it also angered bond investors, causing the yield on Japan's 40-year government bond, seen as a market barometer, to breach the key psychological threshold of 4% for the first time.

The market's strong reaction highlights extreme investor concern over the sustainability of Japan's finances. Fund managers warn that if Takaichi wins a landslide election, trust in her fiscal discipline may further collapse, triggering a sell-off in Japan, the world's third-largest debt market. More seriously, as domestic Japanese yields soar, institutional investors in Japan may speed up repatriating funds from overseas, impacting global long-term bond markets.

Although Japan's Finance Minister Katsuki Katayama argued at Davos that Japan's basic fiscal balance in 2025 would be the best among G7 countries, and tried to soothe markets with promises of "smart spending," traders point out that once the election order is given, the concept of "responsible fiscal expansion" is already bankrupt in the eyes of the market. While the Bank of Japan's policy interest rate remains below inflation, the loss of control over long-term yields suggests the market is repricing Japan's sovereign risk.

The Epicenter of the Global Bond Market and the Risk of Capital Repatriation

As Takaichi's aggressive fiscal plan advances, Japanese government bond yields are undergoing a historic repricing. In addition to the 40-year yield breaking 4%, the benchmark 10-year JGB yield has also recently surpassed 2%, reaching its highest level in over a quarter-century. The yields on 20-year and 30-year JGBs have also hit new highs, with the 30-year yield now exceeding that of German bonds of the same maturity, and is approaching Spanish bond levels.

This surge in yields has triggered global investor vigilance. Mike Riddell, a fund manager at Fidelity International, pointed out that the huge yield attraction is prompting major Japanese investors to sell overseas assets and repatriate funds. This capital repatriation trend is hurting long-term bond performance in other parts of the world.

For a long time, investors questioned the debt sustainability of France, the UK, and the US, but now the focus is turning to Japan. Although Rain Yin, a sovereign analyst at S&P Global Ratings, said that as long as growth remains healthy, rating agencies remain relatively calm about Japan's debt and have accounted for fiscal weakness, the market isn't buying it. It's not just the rise in nominal yields; investors are beginning to reassess the sustainability of Japan's debt burden—at 250% of GDP—under aggressive fiscal policy.

The Reversal of the "Takaichi Trade" and the Yen Dilemma

The market shift also indicates the so-called "Takaichi trade" may be ending. Previously, investors bet that Takaichi's spending plans would cause a weaker yen, a rising stock market, and higher long-term yields. However, Takahide Kiuchi, Executive Economist at Nomura Research Institute, warns the continued rise in long-term yields is starting to negatively impact the economy and financial markets, potentially reversing previous trading logic.

The extreme weakness of the yen has already reached the government's historic intervention threshold, but this puts policymakers in a dilemma: Intervening in the forex market or raising rates to support the yen would further push up yields, undoing any growth effects from fiscal stimulus. Citi's FX strategist Osamu Takashima noted that Takaichi's stance on yen weakness is changing from previous acquiescence to a now more defensive posture, suggesting she may have to support the Bank of Japan in ending decades of ultra-loose policy and return to rate normalization.

Neuberger Berman's Senior Portfolio Manager Robert Dishner believes defending the currency through rate hikes is difficult, as this will directly raise financing costs and could stifle any economic growth from fiscal expansion.

Fiscal Discipline Game Under Election Pressure

Takaichi's policy shift is largely seen as an election strategy. Barclays economist Naohiko Baba analyzes that the tax pledge Takaichi announced Monday marks a major policy reversal, since she had previously strongly opposed cutting the consumption tax, but was forced to change course facing similar pledges from opposition parties.

Although CLSA strategist Nicholas Smith considers Takaichi a "policy geek" who fully understands the gravity of the issue, the market is more focused on how campaign promises will turn into real policy after the election. The fiscal pressure facing Japan comes not only from domestic welfare spending, but also a rising defense budget and a tariff agreement with the US, obliging Japan to underwrite $550 billion in US investments within the next three years.

As Takahide Kiuchi put it, as an election strategy, cutting the consumption tax is easy for voters to understand, but if this must be financed by cutting other spending or raising other taxes, it simply shifts the burden to ordinary people—"there's no such thing as a free lunch." The current market turmoil shows investors are voting with their feet—they're not only doubting Takaichi's ability to deliver on her promises, but also questioning Japan's fiscal future.

Risk Warning and DisclaimerThe market has risks, and investment needs to be cautious. This article does not constitute personal investment advice, nor does it take into account the special investment objectives, financial circumstances, or needs of specific users. Users should consider whether any opinions, viewpoints or conclusions in this article fit their own circumstances. Investments made accordingly are at your own risk.

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