It’s now Japan’s turn for a burst of political instability as Prime Minister Shigeru Ishiba heads for the exit.
Make that global bond markets, too. Over the last two months, the so-called bond vigilantes reacted badly to Ishiba’s Liberal Democratic Party losing its outright majority 50 days ago. The reason: the LDP has had to turn to pro-tax-cut opposition parties to maintain power.
The specter of budget-busting tax cuts sent Japanese yields to the highest levels in decades. That also led to a series of weak government bond auctions that spooked global debt markets.
But the uncertainty of what comes next might be even greater. Particularly at a moment of decidedly fractured politics in Tokyo. “Whoever takes over will be walking a tightrope,” says Stefan Angrick, Japan economist at Moody’s Analytics.
As Angrick notes, Ishiba’s exit comes as little surprise. He struggled to articulate a compelling vision for the economy and failed to resonate with the public, who were struggling with a cost-of-living crisis. Ishiba, a fiscal conservative, repeatedly dismissed policy options, whether from the opposition or his own party, as too populist.
“But while the leadership transition will generate political noise, expectations for major policy shifts are premature,” Angrick notes. “Predictable punditry will cast moderates as prudent technocrats and conservatives as reckless spenders who will lean on the Bank of Japan to sustain cheap money forever.”
The truth, he adds, is that even party moderates who want to keep spending tight will have to respond to voter frustration with inflation and confront the rise of right-wing populism. “And conservatives favoring bigger budgets will need to accept that Japan’s economy needs more than demand stimulus,” Angrick notes.
All this worries the so-called “bond vigilantes.” With a debt-to-GDP ratio approaching 260% and Japan’s population aging in real time, debt investors are reluctant to increase their yen exposure.
At a minimum, the uncertainty makes it less likely the Bank of Japan will be hiking interest rates anytime soon. Doing so at either this month’s or the October policy meeting could unnerve the bond market.
The Japanese government bond (JGB) market has had a chaotic 2025. In mid-May, for example, turmoil related to US President Donald Trump’s tariffs quickly ended up on Japanese shores, with government bond yields spiking in headline-grabbing ways.
The volatility culminated with a failed 20-year bond auction. The typically routine sale of US$6.9 billion issues maturing in 2045 drew the least interest since 2012. The “tail,” gap between the average and lowest-accepted prices, was the worst since 1987.
Suddenly, #JGBCrash was trending in Asian cyberspace. It was Tokyo returning the favor, sending shockwaves back toward the US. In late May, US Treasury Secretary Scott Bessent expressed concern that turmoil in Japan was pushing US yields higher, the way Treasury market turmoil had unnerved Japan earlier that month.
That same month, Ishiba hardly helped things by saying that Japan’s deteriorating finances are “worse than Greece.” It put Japan in global headlines for all the wrong reasons at the worst possible moment.
Ishiba was making a more nuanced point than that. His argument was aimed at lawmakers planning to cut taxes. Ishiba framed it as a luxury Japan couldn’t afford, given its lack of fiscal space. Yet his gaffe went viral in market circles — in the worst possible ways. No doubt it drew the attention of credit-rating companies everywhere.
Yet some observers think investors’ worries are overdone. Masahiko Loo, senior strategist at State Street Global Advisors, notes that around 90% of JGBs are domestically held, and the ‘don’t fight the BOJ/Ministry of Finance’ mantra remains a powerful anchor.
Any perceived supply-demand imbalance is more a matter of timing mismatches, which is a technical dislocation rather than a fundamental flaw. We expect these imbalances to be resolved” as early as the current quarter.
Recently, though, the 20-year JGB rate rose to 2.655%, the highest level since 1999. It sparked a level of volatility Tokyo markets haven’t seen in years.
Since 1999, a succession of BOJ leaders have been trying to get short-term rates closer to 1% than 0%. To no avail. Today’s BOJ Governor Kazuo Ueda has gotten no further away from zero than his peers during an earlier 2006-2007 tightening cycle.
“There may be growing expectations that macroeconomic policy could tilt toward easing among foreign investors in particular,” says Takeshi Yamaguchi, economist at Morgan Stanley MUFG. But, he adds, “regardless of the political situation, if weak US economic data— including employment data—continue, the bar for the BoJ to raise rates will likely become higher.”
Could the BOJ’s next move be to cut rates, not raise them? It’s possible given the widening fallout from Trump’s tariffs. Yet investors have every reason to worry that a new government in Tokyo will change little about the direction of Japanese politics and the economy.
“Regardless,” say economists at BMI, a unit of Fitch Solutions, “the next prime minister would still face the same problematic legislative dynamics as Ishiba, unless a bigger coalition is formed.
“We thus see a possibility that a new LDP premier could seek to take advantage of their putative honeymoon period to call a snap general election, with the aim of at least recovering the LDP’s majority in the House of Representatives. Even so, this would be a gamble, as Ishiba himself discovered when he inadvertently led the LDP into a lower house minority position in October.”
The frontrunners to replace Ishiba are LDP party mates Shinjiro Koizumi and Sanae Takaichi. At 44, Koizumi, former environment minister and scion of a political dynasty, represents generational change. Then-Economic Security Minister Takaichi, 64, would be the nation’s first female leader.
David Boling, an analyst at Eurasia Group, expects moderates within the LDP to rally around Koizumi, known for his youth and charisma, while conservatives are expected to support Takaichi, a staunch nationalist and apostle of Abenomics,” a mix of loose monetary and fiscal policy championed by 2012-2020 Prime Minister Shinzo Abe.
“Investors will closely watch Takaichi’s electoral prospects because of her previous pointed criticism of the Bank of Japan’s plans to raise interest rates, and her support for larger fiscal stimulus,” Boling notes.
Yamaguchi notes that many investors, especially foreign ones, believe that if Takaichi becomes the next prime minister, fiscal and monetary policy may shift toward expansion.”
However, he adds, BOJ Governor Kazuo Ueda “is focused on hard data from the US, and following last week’s employment statistics, it appears that the hurdle for a rate hike by the BOJ has increased regardless of the political situation.”
The media, Yamaguchi observes, is reporting several other names, including Yoshimasa Hayashi, chief Cabinet secretary, Takayuki Kobayashi, former minister for economic security, and Toshimitsu Motegi, former LDP secretary-general.
The trouble, of course, is that none of the obvious candidates is known to be an economic reformer. That’s a problem, considering that the LDP has largely squandered the last 25 years during which it had a wide window of opportunity to remake Japan.
Japan’s preexisting conditions are another problem. A quarter century of zero rates and a weak yen deadened the urgency to reduce bureaucracy, internationalize labor markets, rekindle innovation, increase productivity or empower women.
The nation’s weak yen addiction is also catching up with Asia’s third-biggest economy. For more than 25 years now, a revolving door of governments has actively weakened the yen to boost exports and corporate profits.
It deadened the urgency for policymakers and CEOs alike to raise Japan’s competitive game. It’s a key reason why it will fall to the leader who replaces Ishiba to get serious about cutting bureaucracy, loosening labor markets, leveling playing fields, supporting a startup boom and empowering women.
Whatever happens, though, the high odds Japan is about to borrow and spend its way to faster growth, triggering activist bond traders to push yields higher in sync with political volatility.
Follow William Pesek on X at @WilliamPesek
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