“No one dares to catch the flying knife”! The concern in Japan’s bond market is: Where will the money come from for the 5 trillion yen consumption tax reduction?

As Japan’s general election approaches, concerns about the collapse of fiscal discipline are rapidly spreading in the Japanese bond market. Investors are showing extreme caution in the face of potentially massive, unfunded tax cut promises.

According to Xinhua News Agency, Japanese Prime Minister Sanae Takaichi stated at a press conference on the 19th that she plans to dissolve the House of Representatives on January 23 and hold general elections for the House on February 8. Takaichi announced preparations to eliminate the consumption tax on food for two years, although funding for this tax cut is still under consideration. She may cut subsidies and adjust the overall budget. The sustainability of Japan’s fiscal situation will be ensured by reducing the debt-to-GDP ratio.

Analysts believe that if the policy to eliminate the consumption tax on food for two years is implemented, it is expected to result in an annual tax cut of about 5 trillion yen. What makes the market uneasy is that the Japanese government has not disclosed specific funding sources to fill this massive fiscal gap.

As a result, the Japanese government bond market is facing severe selling pressure. On Tuesday, fears of fiscal expansion combined with weak demand at the 20-year bond auction led to historic selling; the yield on 30-year Japanese government bonds rose 26.5 basis points to 3.875%, while the yield on 40-year bonds rose 27 basis points to a new record high of 4.215%.

The market generally worries that if Takaichi cannot provide a concrete financing plan apart from relying on “economic growth,” investors will be forced to reprice Japan’s sovereign risk. Nomura Securities’ Chief Rate Strategist Naka Matsuzawa warned that long-term and ultra-long-term Japanese government bonds will likely exhibit extreme volatility around “speculation about food consumption tax cuts” and “sources of funding for tax cuts.”

5 Trillion Yen Gap and “Vague” Sources of Funds

Nomura's analysis indicates that the ruling party is currently weighing this tax cut proposal, which has clear electoral strategic intentions. The Liberal Democratic Party is considering this policy in part to align with the Japan Innovation Party, which advocates the same proposal, and also to counter similar tax cut calls from the centrist reform alliance.

However, for the bond market, this strategy comes at a high cost. Temporarily suspending the food consumption tax for two years would mean a loss of about 5 trillion yen in annual fiscal revenue.

In his report, Naka Matsuzawa warned that the Takaichi government may claim that the unexpected tax revenue generated by economic growth would cover this expenditure, but this is difficult for cautious market participants to accept. In the absence of clear plans for tax increases or spending cuts, such “unfunded” fiscal expansion directly undermines investor confidence in Japan’s fiscal sustainability.

No One Wants to Catch a Falling Knife

With doubts about fiscal discipline, the yield curve at the long end of Japanese government bonds is becoming unusually fragile.

Nomura expects that, due to weak bond markets in the US and Europe, coupled with the negative impact of Japan’s domestic tax cut proposal, the Japanese bond market will remain on a downward trend. Although a strong yen and safe-haven sentiment from the US may provide some support, the long and ultra-long end Japanese bonds are likely to bear the brunt as an outlet for market concerns over fiscal deterioration.

Meanwhile, market expectations for normalization of Bank of Japan (BOJ) policy have not subsided. Current market pricing indicates that the probability of the BOJ raising interest rates in April has risen to 61%. Although Naka Matsuzawa believes that the conditions for a market consensus (i.e., probability over 70%) are not yet fully met, the dual pressures of rate hike expectations and fiscal deterioration are intensifying valuation pressures on Japanese government bondholders.

Masahiko Loo, Senior Fixed Income Strategist at State Street Global Advisors, commented:

“Takaichi trades” are still very active. The simplest strategy is to short the yen, short Japanese government bonds or push yields higher, and then go long the Nikkei index.

Herd mentality in Japan is very serious. That’s why all the banks aren’t buying bonds. Why aren’t they buying? Because they’re all waiting for the BOJ to raise interest rates.

No one wants to catch a falling knife.

Policy Directions under Electoral Competition

Market analysts generally believe that Takaichi’s decision to dissolve the House and hold elections at this time is more a political tactic, seeking re-election at the most favorable moment, rather than representing a fundamental shift in economic policy.

Nomura’s report points out that Takaichi may continue to use vague language such as “responsible and active fiscal policy” to reassure stakeholders. For investors, the key thing to watch is tonight’s press conference: will she formally list the food tax reduction as a campaign pledge, and will she detail the source of funding? If the government merely emphasizes national security issues or seeks a mandate to change coalition partners while staying vague on fiscal details, market anxiety over Japan’s fiscal outlook may be hard to ease.

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