Japan’s political noise shouldn’t cloud steady fundamentals

Will Japan change leadership after July? Prime Minister Ishiba Shigeru is struggling with a minority government ahead of an election for the upper house of Japan’s parliament, due before 22 July. While investors debate the possible political and fiscal impacts, we see room for eventual stabilisation in sovereign bonds and increased strength in the stock market.

Macro outlook: Slower global growth, stable to lower central bank rates than originally expected  

Analysts predict that the ruling coalition, led by Mr Ishiba, will lose seats in Japan’s upper parliamentary chamber, the House of Councillors, and then face pressure to resign. If he does so, the race for Japan’s leadership would be wide open with challenges from inside and outside the ruling Liberal Democratic Party (LDP). The outlook could become even less clear if Mr Ishiba calls a snap lower house election, turning the election date into a vote for both parliamentary chambers.

Investors worry that the election threatens to set back Japan’s fiscal discipline. The prime minister has maintained the government’s cautious medium-term guidance on its budget, despite his rising political isolation. The government’s reductions to pandemic-related support, and relative spending discipline, have narrowed fiscal deficits. But this would be reversed by new stimulus proposed by opposition parties. 

Competing fiscal proposals

Mr Ishiba’s rivals have tried to capitalise on growing public anger at the rising cost of living. The implications for easing fiscal discipline would be significant. The complete removal of an 8% consumption tax on food, favoured by the centre left Constitutional Democratic Party (CDP) and one of Mr Ishiba’s LDP adversaries, Mrs Takaichi Sanae, would cut annual revenue by around JPY 4 trillion (USD 28 billion).The CDP is currently proposing a two year reprieve on food VAT in addition to eliminating petrol tax, and one-off cash handouts worth JPY 20,000 per person. 

Meanwhile, the centre-right Democratic Party for the People’s (DPP) Mr Tamaki Yuichiro, is focussed instead on raising an income tax exemption threshold for the first time since 1995. That would target lower income workers who face higher tax burdens as their wages rise, but cut Japanese government revenue by as much as JPY 8 trillion per year. The DPP is also proposing to implement an across-the-board cut in consumption taxes to 5%. Together, these proposals would undo much of former Prime Minister Shinzo Abe’s tax base expansion, and undermine other strategic priorities, including higher defence spending.

JGB jitters look slightly excessive

The ruling coalition is under pressure on these tax proposals due to the widespread backlash against the spiking prices of crucial consumer staples such as rice, and they appear to be adopting some populist pledges with a one-off cash handout of their own. Ultimately, the Ishiba cabinet is still guiding for a more conservative budget without permanent consumption tax cuts, or a sharp rise in annual minimum taxable income levels. 

JGB yields have repriced sharply in 2025. The 10-year yield stands at 1.46%, while the 30-year note has risen to nearly 2.90%

This prospect of greater budget shortfalls under a possible new cabinet explains investors’ unease over Japan’s government bond (JGB) markets. JGB investors have also had to cope with the BoJ’s balance sheet reduction, monetary policy normalisation, and regulation-related shifts in demand for longer-dated bonds. JGB yields have repriced sharply in 2025 as a result, particularly in longer maturities. The 10-year yield stands at 1.46%, while the 30-year note has risen to nearly 2.90%, reflecting investor demand for greater compensation to hold longer maturities in an environment of fiscal uncertainty and global bond volatility. 

However, in our view, political instability may not disturb Japan’s financial market as much as investors fear. First, the ruling coalition may yet defend its majority in the upper house, and so keep its current conservative fiscal policy guidance in place. Second, an environment forcing the prime minister to quit could be too chaotic to allow any agreement around a new stimulus package. Third, any supplementary budget that serves as a middle ground for competing proposals could be rather modest in its ultimate impact on debt, while slightly supportive for near-term growth. 

Eventual stabilisation ahead  

Furthermore, BoJ policy will probably stabilise JGBs. While economic activity and inflation have proven reasonably resilient despite disruptive US trade policies, the lack of a US trade deal and subsequent industrial uncertainties, will prevent the BoJ from making hawkish noises in the next few months. 

Markets are currently pricing a possible additional BoJ rate hike by the year-end. In contrast, our base case suggests that the BoJ will keep its benchmark rate on hold at 0.5% until the end of the year, and only resume gradual rate hikes in the first quarter of 2026 as pressure on services inflation moderates, and recent rates turmoil subsides. 

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This said, better economic data and a US trade deal could bring forward another rate hike to the end of 2025. As for JGB market intervention, the BoJ will take a practical approach if JGB volatilities persist, aligning its purchases with the Finance Ministry’s bond issuance. The US dollar’s weakness in recent months also makes it easier for Japan’s central bank to consider temporary liquidity injections into the system. 

We are approaching the upper bound of yield repricing: once a full hike is priced in, we see even more scope to extend our maturity preference

While we see the potential for continued rate volatility – especially around currency market dynamics and the global repricing of risk assets – current yield levels are increasingly attractive for long-term investors. In particular, foreign buyers looking for currency-hedged income in US dollars, while inflows from Japanese investors could help to stabilise demand for longer-maturity bonds. With market expectations for the country’s terminal interest rate nearing a peak, we are approaching the upper bound of yield repricing: once a full hike is priced in, we see even more scope to extend our maturity preference. 

With short-maturity bonds now reasonably priced and long maturity bond valuations looking stretched we like JGBs , in particular the 5-year maturity, and remain ready to raise our exposure in the event of further yield spikes. 

Positive reform momentum to provide a steady stock market tailwind  

To many international investors, Japan’s equity market seems beset by macroeconomic uncertainty and volatility. In the last few months, sceptics might point to the LDP’s loss of its parliamentary majority, the BoJ’s monetary policy U-turn, an economy targeted by US tariffs, and a highly volatile currency. 

Yet reforms to the Japanese stock market have been going from strength to strength, independently of macroeconomic domestic or international news flow, supported by a series of reforms: the Tokyo Stock Exchange has raised the liquidity bar for firms to stay listed, and new takeover guidelines and the dissolution of policy shareholdings held by financial institutions have boosted share buybacks. 

These measures should enhance capital efficiency and investors’ return on equity. They also improve corporate governance and increase shareholder influence. We therefore see potential for foreign investors to return to the Japanese market (see chart 3) in the years ahead as the country turns from a satellite market to a core of global portfolio allocations. 

In addition, corporate actions boost our confidence in continuing reforms. There is a shift in corporate from merely meeting targets to prioritising shareholder value and maximising market capitalisation. As a result, we see growing awareness among Japanese companies of the importance of shareholder value and capital allocation. Recent corporate deals showcase Japan’s reform progress, and highlight the value that remains to be unlocked. Historically considered taboo, unsolicited takeovers are increasingly frequent, underlining the willingness of Japanese investors to finance deals and deploy excess balance sheet capital. 

With the US dollar-Japanese yen currency pair overvalued and the Federal Reserve likely to gradually cut rates, we assume USDJPY will move lower over the next 12 months. We neutralised a long yen preference in early May, and the pair has been in a broad 143 to 148 range since. We expect this to continue until the Fed begins cutting interest rates, which should give way to lower levels.