Investor apprehension has reignited in Japan's bond market following Prime Minister Sanae Takaichi's decisive election victory. While her win initially garnered a positive response from investors, they remain cautious about the potential for another market downturn triggered by her expansive spending plans. At her first press conference after Sunday's historic win, Takaichi acknowledged market concerns regarding her strategy to simultaneously increase defense and strategic industry spending while extending a food sales tax cut for two years. Last month, bond yields surged to multi-decade highs due to fears she might further inflate Japan's massive public debt burden.

Takaichi emphasized the prudence of her "responsible proactive fiscal policy," while insisting Japan "must break away completely from excessive austerity and chronic underinvestment in the future." Her gamble relies on persistent inflation and faster nominal economic growth filling any fiscal gaps in the coming years. However, investors are seeking more concrete details. Matthew Ryan, Head of Market Strategy at financial services firm Ebury, stated, "The threat of further spending expansion and increased debt issuance, at a time when public finances are already extremely stretched, will add to risk premiums and could trigger a fresh round of bond selling and yield spikes."

During market volatility in January, investors frantically sold bonds, pushing long-term Japanese Government Bond (JGB) yields above 4%. The repercussions spread to global financial markets, prompting comments of concern from US Treasury Secretary Scott Bessent. This week, Takaichi asserted that the government would not issue new bonds to cover the spending gap. Instead, her administration will review subsidies, special tax measures, and non-tax revenues to identify "sustainable" funding sources. Naomi Muguruma, Chief Bond Strategist at Mitsubishi UFJ Morgan Stanley Securities, noted, "Market concern is brewing over the funding source for these measures and whether they will ultimately resort to issuing deficit-covering bonds. A fundamental worry is that the tax cut risks being extended beyond two years."

Historical precedent validates these concerns. The introduction of Japan's sales tax took roughly a decade, and each subsequent increase has caused economic contractions, with annualized declines reaching up to 11%. Delays in the two most recent hikes highlight the political difficulty of raising taxes, casting doubt on the feasibility of restoring rates after a temporary reduction.

In defense of the government's spending plans, Finance Minister Satsuki Katayama pointed out that new bond issuance for the FY2026 annual budget has been held below 30 trillion yen (approximately $195 billion) for the second consecutive year. The two-year suspension of the food sales tax will cost 5 trillion yen annually. One proposed solution to cover the shortfall involves utilizing non-tax revenue sources, such as funds generated from the Finance Ministry's foreign exchange reserves, including profits from currency market interventions. The estimated surplus for this account this fiscal year is around 4.5 trillion yen, with 70% available for budget financing under ministry guidelines. Yet, alternative funding sources are still needed if the government aims to cut taxes without increasing bond issuance.

Ayako Fujita, Chief Japan Economist at JPMorgan Securities, commented, "Her election victory is too significant for her not to proceed with the tax cut. Markets must remain vigilant." The yield on Japan's benchmark 10-year government bond has been hovering near 2.2%, nearly double the level from a year ago and above the 2% rate assumed in the budget for the fiscal year ending in March. This shift translates into a substantial cost burden for the government as it issues new debt at higher rates to refinance maturing bonds. These costs could rise further if the Bank of Japan (BOJ) considers additional interest rate hikes, thereby exerting upward pressure on yields.

Japan's debt surpasses twice the size of its economy. Over the past decade, debt servicing costs have grown by one-third and now account for a quarter of the annual budget. Ayako Fujita added, "I hope the Takaichi government will conduct a proper and prudent assessment of the increase in debt servicing costs. With the central bank raising rates, the reality is that costs will inevitably rise."

Takaichi is attempting to shift focus from annual budget balancing to reducing the debt-to-GDP ratio, currently around 230%. According to International Monetary Fund (IMF) projections from October last year, Japan's primary budget deficit—the overall deficit excluding net interest支出—was 0.9% last year, the lowest level since 1992. Tax revenues have more than doubled since the late 2000s following the global financial crisis. The primary balance has returned to within surplus targets.

As an indicator of market views on default risk, Japan's sovereign credit default swaps (CDS) are around 26 basis points, similar to France and lower than the United States. Fitch Ratings stated last month that there are no current plans to downgrade Japan's credit rating, as a shift towards more expansionary fiscal policy had been anticipated. Brian Coulton, Chief Economist at Fitch Ratings, said in an interview, "If you look at the nominal growth rate of the Japanese economy, this is a huge shift we've seen in the last couple of years because we've moved back to positive inflation. That actually means the economy looks healthier in a broad sense, and I think that is alleviating some concerns about the underlying fiscal dynamics."

While inflation alleviates Japan's fiscal pressures, the BOJ's policy normalization is increasing the vulnerability of long-term bonds. BOJ Governor Kazuo Ueda abandoned bond purchases as a tool to control yields in March 2024, and the central bank has since been reducing its purchases. Although the BOJ still holds half of all outstanding bonds, it no longer intervenes in the market with additional purchases when yields rise. Furthermore, global investors, whose capital moves faster than that of local long-term holders, now account for approximately 65% of monthly cash trading volume in the JGB market.

The BOJ has indicated it would take additional action in extraordinary circumstances, such as a global financial shock, but its inaction during January's bond market volatility suggests such events are largely viewed as necessary "growing pains" during the policy normalization process. Whether an ambitious Prime Minister Takaichi will pressure the central bank to act in the future remains to be seen.

Regulatory changes for life insurers and banks have also made it more difficult for them to fill the void left by the central bank amid rising yields. New rules make it challenging for banks to hold long-term bonds due to the short-term nature of their deposit liabilities. Life insurers, having increased holdings to match long-term policy payout obligations under revised regulations, currently have little need to add more such debt.

Regarding the election outcome on Monday, Takaichi stated that negotiations with opposition parties on the sales tax are necessary given the complexity of the issue, with preliminary conclusions expected by summer. This may still leave room for alternative, less costly measures or options that avoid the challenges of a temporary tax cut. Naomi Muguruma of Mitsubishi UFJ Morgan Stanley Securities noted that with the opposition's crushing defeat, "checks and balances on the Takaichi government have effectively weakened. This makes financial markets the only force capable of exerting restraint at present."