Japan’s Debt Trap

Key Points

• Japanese PM Sanae Takaichi led her Liberal Democratic Party to a resounding 316 out of 465 seats win in Sunday’s snap election for Japan’s lower house.
• The Yen strengthened, and long-term bond yields declined on the result.

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Japanese Prime Minister Sanae Takaichi delivered the country’s first post-war supermajority in Sunday’s snap election. Her Liberal Democratic Party won 316 out of 465 seats in Japan’s powerful lower house.

Japan has struggled to recover since industrial production plateaued in the 1990s.

The arch-conservative leader has pledged to suspend the 8% sales tax on food, called for a return to the large-scale fiscal stimulus deployed by former Prime Minister Shinzo Abe (2006-2007 and 2012-2020), and wants to revise Japan’s pacifist constitution. (Reuters)

Fears over rising inflation have driven up long-term interest rates, threatening a fiscal crisis as servicing costs rise on Japan’s precarious government debt levels.

The Japanese Yen strengthened against the Dollar, but remains in a long-term downtrend. The Yen has weakened considerably since Takaichi’s appointment in October 2025. However, currency markets hope that Takaichi’s resounding victory will ease pressure to adopt populist policies promoted by opposition parties.

Takaichi seeks to follow a fiscal path similar to that of Japan’s longest-serving prime minister, Shinzo Abe, with large-scale fiscal stimulus, which is commonly referred to as “Abenomics.” However, inflation is much higher than during Abe’s tenure, which ended in 2020. Japanese CPI excluding food and energy (termed “core core” in Japan) remains stubbornly high at 2.9%.

Bond markets are demanding increased compensation for inflation risk, with the 30-year Japanese bond yield climbing above 3.75% before retracing to test support at 3.5% after the snap election result.

The Bank of Japan has slow-walked the pace of increases in its policy rate. The real overnight bank rate remains deeply negative at -2.15% (0.75% minus 2.9%), heightening fears of high inflation.

Rising Japanese interest rates, accompanied by a weakening Yen, have alerted bond markets to a potential fiscal crisis. Rising rates typically strengthen the domestic currency by attracting inflows of foreign capital. The weakening Yen warns of the opposite: capital outflows despite higher interest rates, as bond markets are wary of inflation risk.

Japanese stocks have soared on expectations of higher inflation, with the Nikkei 225 index in a strong uptrend.

Conclusion

Japanese Prime Minister Sanae Takaich’s resounding victory in Sunday’s snap election provides her with the political cover needed to make the tough decisions necessary to avoid a fiscal crisis. Whether she is sufficiently pragmatic to seize this opportunity will become evident in the months ahead.

Japan is in a debt trap.

The pursuit of large fiscal stimulus risks a budgetary crisis as higher inflation drives up bond yields, threatening a budget blowout. Intervention by the Bank of Japan to suppress long-term interest rates through large bond purchases would risk a currency crisis, with a collapse of the Yen.

Japan’s long-term bond yields are artificially low, supported by the Bank of Japan’s large-scale bond purchases. The chart below from Robin Brooks compares JGB 30-year yields (JP) with the yield on Germany’s 30-year Bund (DE). Both bonds offer similar yields despite substantial differences in the two countries’ debt-to-GDP ratios.

We expect that the Yen will continue to weaken until the above disparity is rectified, with capital flowing out of Japan into more secure markets.

A weak Yen, or higher Japanese interest rates, has far-reaching implications beyond Japan’s domestic bond market. Japanese investors hold $11 trillion of international investments. Rising domestic interest rates, a falling Yen, or attempts to support the Yen by selling reserve assets — can destabilize international capital markets, driving up long-term bond yields.

Acknowledgments

• Trading Economics: Japan CPI
• Reuters: Take Japan’s triumphant Sanae Takaichi at her word
• Yardeni Research: Japan
• Robin Brooks: Japan’s Yen Debasement
• Reuters: Yen Crisis Tracker