Japan's upcoming election spokes investors as higher spending plans risk destabilizing bond markets

The bond market in Japan is cracking under pressure, and all fingers are pointing to one thing: the upcoming Upper House election on July 20.

What should be just another political shuffle is now looking like a trigger for a financial shake-up, both inside the country and far beyond.

With government bond yields already hovering near record levels, investors are bracing for more volatility, especially if fiscal policy turns looser and debt starts ballooning again.

It’s not just about numbers anymore. This election could change Japan’s entire economic direction. Voters are being offered promises of cash handouts and cuts to the consumption tax, which may look good on paper but spell trouble for bond markets already dealing with rising inflation and interest rate uncertainty.

Bond vigilantes circle Japan’s debt like sharks

The phrase “bond vigilantes” is being whispered in financial circles again, and Japan may be their next big play. These are fixed-income investors who bail on buying government debt when they think the risk isn’t worth the return. The idea of them targeting Japan used to be absurd. After all, the Bank of Japan owns over half the national debt, and it kept tight control of the yield curve for years.

But that was the old Japan. Now inflation is rising, debt is mounting, and policy is shifting. Ed Yardeni, the veteran investor who coined the term “bond vigilantes” back in the 1980s, believes we’re heading right back into that territory.

In a note from Yardeni Research, the firm warned about “the high odds that the next Japanese government turns to tax cuts and increased spending in ways that trigger the Bond Vigilantes.” And once they’re spooked, the whole global bond market could feel the ripple.

Japanese long-term bond yields at the 30- and 40-year marks have already jumped nearly one full percentage point over the past year. If things keep trending like this, that jump will look small in hindsight. And the kicker? This election is also being seen as a referendum on Prime Minister Shigeru Ishiba’s coalition. If his grip weakens, expect the debt trajectory to tilt even more aggressively.

Chief economist Joseph Brusuelas from RSM said, “It’s a preview of coming attractions as the U.S. has to address competing demands for scarce federal dollars which typically result in increased government spending, higher interest rates, higher yields and higher inflation.” In other words, Japan might just be showing the world what’s next.

Credit downgrade fears grow with promises of tax cuts

Here’s the real fear: Japan’s credit rating might be headed for a downgrade. That’s not just speculation—it’s showing up in the numbers. Bloomberg data shows interest payments as a percentage of revenue are climbing fast. This year, that figure is expected to hit 12.2%, up from 9.9% just one year ago. If that trajectory holds, it’ll hit an eight-year high by March 2026.

The last time this ratio topped 13%, back in 2015, S&P Global Ratings downgraded Japan’s credit to A+. The difference is, back then, there was no panic. The BOJ was running a massive stimulus program and buying bonds like candy. That’s no longer the case. Inflation is up. The central bank is trying to pull back. And that means the safety net is gone.

A downgrade today wouldn’t just hit Japan. It would trigger global effects because Japanese investors are the largest foreign holders of U.S. Treasury bonds. And with the BOJ no longer suppressing long-term yields like it used to, any instability in JGBs (Japanese government bonds) flows straight into global markets. Bloomberg’s analysis of the 10- to 30-year spread confirms that those bonds have become far more reactive to even minor shocks.

Bo Zhuang, a strategist with Loomis Sayles Investments Asia, warned, “If the Liberal Democratic Party were to lose its majority in the upcoming Upper House election, it might force it to accept a broader consumption tax cut, which would be a major blow.”

Zhuang also said foreign investors would likely reduce exposure to Japanese government bonds if debt sustainability becomes a front-page issue again. And at this point, with campaign promises centered around tax cuts and handouts, that’s no longer a hypothetical. It’s what the market is pricing in.

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