The panic in the Japanese bond market reignites! Finance Minister Takanoe Takamichi's fiscal risk-taking is met with investors' cold eyes, and the market is worried that the January selling spree will happen again.

Notice that Japanese Prime Minister Kanichi Hayashi won the election with overwhelming support, initially gaining a positive response from investors. However, investors remain cautious about another round of market collapse that may be triggered by her expansionary spending plans. At her first press conference after achieving a historic victory on Sunday, Kanichi Hayashi acknowledged concerns from the market about how she plans to increase defense and strategic industry spending while also implementing a two-year plan to reduce the food sales tax. Worries about further raising Japan's already mountainous public debt led to a spike in bond yields last month to the highest levels in decades. Kanichi Hayashi emphasized the prudence of her "responsible proactive fiscal policy" while insisting that Japan "must completely break free from excessive austerity and insufficient long-term investment for the future." Her bet is that sustained inflation and faster nominal economic growth will make up for any deficits in the country's finances in the coming years. However, investors are hoping for more clarity on the details. Matthew Ryan, market strategist at financial services company Ebury, said, "In a situation where public finances are already extremely tight, the threat of further expenditure increases and additional debt issuance will raise risk premiums and could trigger a new round of bond selling and yield spikes." During the market turmoil in January, investors frenzy selling bonds pushed long-term Japanese government bond (JGB) yields above 4%, causing a ripple effect in global financial markets, prompting US Treasury Secretary Scott Bennett to express concerns. This week, Kanichi Hayashi insisted that the government will not fill the spending gap by issuing new bonds, but rather stated that her government will review subsidies, special taxation measures, and non-tax revenues to find "sustainable" sources of funds. Naomi Muguruma, Chief Bond Strategist at Mitsubishi UFJ Morgan Stanley Securities, said, "Concerns are brewing in the market about the sources of funding for these measures and whether there will be resorting to issuing deficit compensation bonds in the end. A fundamental concern is that the risk of tax cuts may persist beyond two years." History has shown that these concerns are not unfounded. It took approximately ten years for Japan to introduce the sales tax, and each subsequent tax increase has led to economic contractions, with annualized declines reaching 11%. The recent delays in the two most recent tax increases also demonstrate the political difficulties of raising taxesraising doubts about the challenges of reinstating tax rates after temporary reductions. To defend the government's spending plan, Finance Minister Soko Katsuyuki pointed out that in the budget for the fiscal year 2026, the volume of new bond issuance has been kept below 30 trillion yen (approximately $195 billion) for the second consecutive year. The temporary suspension of the food sales tax for two years will cost 5 trillion yen annually. One solution to filling the gap is to use non-tax income sources, such as funds generated by the Ministry of Finance's foreign exchange reserves, including earnings from intervening in the currency market. The estimated surplus in this account for this fiscal year is approximately 4.5 trillion yenaccording to the ministry's guidelines, 70% of this can be used for budget financing. However, if the government wants to cut taxes without issuing new bonds, they will need alternative sources of funding. Ayako Fujita, Chief Economist at J.P. Morgan Securities, said, "Her victory margin is so large that she cannot help but pursue tax cuts. The market must remain vigilant." Japan's benchmark 10-year government bond yields have been hovering around 2.2%, almost double compared to the same period last year, and higher than the 2% assumed in the March fiscal year budget. As the government issues new bonds at higher rates to pay off expiring old debt, this change translates into a significant cost burden for the government. With the Bank of Japan considering further rate hikes, these costs may continue to rise, putting upward pressure on yields. Japan's debt has exceeded twice the size of its economy, and over the past decade, debt-servicing expenses have grown by a third, now accounting for one-quarter of the annual budget. Ayako added, "I hope the Kanichi Hayashi government can make a proper and careful assessment of the increased costs of debt servicing. As the central bank raises rates, the reality is that costs will inevitably rise." Kanichi Hayashi is trying to shift the focus from balancing the annual budget to reducing the ratio of debt to GDP, which currently stands at about 230%. According to the International Monetary Fund's forecast in October last year, Japan's overall budget deficit, excluding net interest payments, was 0.9% last year, the lowest level since 1992. Since the late 2000s, tax revenue has more than doubled since the global financial crisis. As a measure of market default risk, Japan's sovereign credit default swap (CDS) stands at around 26 basis points, similar to France and lower than the United States. Fitch Ratings stated last month that there are no plans to downgrade Japan's credit rating, as they had already anticipated Japan's shift towards a more expansionary fiscal policy. Fitch's Chief Economist Brian Coulton stated in an interview, "If you look at the nominal growth rate of the Japanese economy, it is a massive turnaround we have seen in the last few years, as we are back to positive inflation. This actually means the economy looks healthier in a general sense, and I think this is easing some concerns about the potential fiscal dynamics." While inflation has alleviated Japan's fiscal pressures, the normalization of the Bank of Japan's policies is increasing the vulnerability of long-term bonds. In March 2024, Bank of Japan Governor Kazuo Ueda abandoned using bond purchases as a tool to control yields, and the central bank has been reducing its purchase sizes. Although the central bank still holds half of the outstanding bonds, it no longer intervenes in the market by making additional purchases when yields rise. Additionally, global investors, who trade cash transactions amounting to around 65% of Japan's government bond market monthly, are faster in and out compared to local long-term holders. The Bank of Japan has stated that it would take additional actions in the event of unconventional circumstances such as a global financial shock. However, its inaction during the bond market turbulence in January indicates that such events are largely seen as necessary "growing pains" in the process of policy shift. The ambitious Kanichi Hayashi's future actions towards pressuring the central bank to act are still to be observed. Changes in life insurance and banking regulatory rules make it more challenging for them to fill the space left by the central bank as interest rates rise. The new regulations make it difficult for banks to hold long-term bonds as their deposit liabilities are short-term. After increasing holdings to match long-term insurance policy payout obligations based on revised regulatory requirements, there is currently little demand for such bonds from life insurance companies. Kanichi Hayashi stated on Monday, following the election results, that considering the complexity of the issue, negotiations with the opposition party on the sales tax are necessary, and preliminary conclusions will be drawn in the summer. This may still leave room for alternative solutions that are more cost-effective or can bypass the challenges of temporary tax cuts. Naomi from Mitsubishi UFJ Morgan Stanley Securities stated that with the opposition party suffering a severe defeat, "the checks and balances on the Kanichi Hayashi government have effectively weakened. This makes the financial markets the only force capable of exerting constraints at present."