Takashi Sanae's "taboo tax cuts" stumbled the market, and Japan fears it may be difficult to calm the debt market storm.

Japanese Prime Minister Takaichi Sanae promised to lower the consumption tax rate, which is considered a taboo in the political arena - even the mentor, former Prime Minister Shinzo Abe, who is famous for his "Abenomics" stimulus policies, did not dare to touch this red line. Now, the Japanese bond market is experiencing violent fluctuations due to this promise, and Takaichi Sanae may have difficulty calming the market turbulence. As Japan's debt scale ranks first among major economies, with a quarter of the fiscal budget needed to repay debt interest, the impact of rising bond yields is particularly severe for Japan. With the upcoming election on February 8th, it is difficult to change policies during the campaign period, and Takaichi Sanae may lack effective means to soothe market sentiment. Investors are increasingly worried about whether Japan's fiscal control ability is getting out of control. "The rise in bond yields this time is a signal from the market that Japan's fiscal confidence is lost," said a source familiar with Takaichi Sanae's economic policies. The anonymous source added, "The Prime Minister must clearly explain to the market how Japan will regain trust, and how the future fiscal framework will be implemented. I think she has realized this, and may take action in that direction after the election." However, Takaichi Sanae may not have enough time to sit and watch. If she delays, she will lose investors' trust completely. Data shows that Japanese 10-year government bond yields surged by 18.5 basis points in two days, marking the biggest single-day increase since 2022, reaching a new high of 2.380% on Tuesday. Japan's government is facing a "Thatcher-style" test of market trust. The soaring long-term government bond yields to historic highs and the slump in the bond market are reminiscent of the "Thatcher shock" in 2022. At that time, former British Prime Minister Leigh Thatcher launched a large-scale tax cut plan without financial support, directly causing a collapse in British government bonds and a historical surge in yields. "From the current selling frenzy, market sentiment is far from optimistic. Japan's long-term government bond market is already like stagnant water," admitted a market investment manager at a local bank, which had almost not bought any Japanese government bonds this year. Such views from market participants ring alarm bells for financial stability in Japan. Currently, Japan's public debt as a percentage of gross domestic product (GDP) has exceeded 230%, ranking first among developed countries. Over 80% of Japan's public debt is supported by domestic savings. The Bank of Japan holds half of the outstanding government bonds in the market, while foreign investors hold only 6.6%, with the rest held by domestic financial institutions and households. Although Japan's current situation differs from the turmoil in the British financial market due to a tax reduction plan without financial support, the Bank of England was significantly and aggressively raising interest rates at that time, while the Bank of Japan has so far maintained its key policy rate at an ultra-low level of 0.75%. In addition, Japan's pension funds have a relatively limited leverage ratio, while the 2022 crisis in the UK was triggered by a liquidity crisis in high-leverage pension funds. Nevertheless, Takaichi Sanae's promise to temporarily suspend the 8% food consumption tax for the next two years only adds insult to injury to the already fragile bond market. The Bank of Japan is currently steadily raising interest rates and reducing bond purchases, and the bond market is facing a huge funding gap with few investors willing to step in. Before the Bank of Japan ends its yield curve control policy in 2024, politicians can launch massive spending plans to please voters without worrying about the risk of soaring bond yields. However, in previous governments, even the signal of lowering the consumption tax would be met with great hesitation, not to mention its actual implementation - they were worried that this would trigger a bond sell-off, further pushing up the financing costs of Japan's massive debt. Even Shinzo Abe, who introduced massive fiscal and monetary stimulus policies in 2012-2013 to help Japan escape the long-term deflation trap, ultimately only postponed the tax increase plan, and in 2019 pushed through an increase in the consumption tax rate. Since then, Japan has been levying an 8% consumption tax on food and a 10% consumption tax on other goods and services. This tax has become Japan's largest source of revenue, providing stable financial support to address the pressures of social security expenditures brought about by the rapid aging population. Japan's demographic and budgetary structures may further amplify the risks of lowering the consumption tax and the subsequent economic impact of a bond market sell-off. Nearly 60% of Japan's fiscal budget is allocated to social security and debt financing, and the scale of these expenditures is likely to continue to rise. In the record-high 122 trillion yen (approximately $771 billion) budget proposal for the fiscal year 2026, about a quarter of the funds rely on bond issuances, with nearly 22% coming from consumption tax revenue. Takaichi Sanae described the plan to temporarily suspend the 8% food consumption tax as her "long-standing wish," but once implemented, it will result in an annual fiscal loss of 5 trillion yen, roughly equivalent to Japan's annual education budget expenditure. Regarding the funding source for this tax reduction plan, Takaichi Sanae has been vague, only stating that it needs to be determined through consultations with other political parties. "Even if the tax reduction period is only two years, the scale of 5 trillion yen is significant," noted Takeshi Minami, Chief Economist at the Norinchukin Research Institute. "Once the consumption tax rate is lowered, it will be extremely difficult to raise it again in the future." According to a draft of the ruling party Liberal Democratic Party's election platform, the party reaffirmed the commitment made by Takaichi Sanae to "temporarily suspend the food consumption tax for two years." There are few tools available On Wednesday, the bond market turmoil in Japan eased temporarily, with the 10-year government bond yield falling to 2.300%, providing a brief respite for the market. However, as the February 8th election approaches and various political parties race to increase spending and tax reduction commitments, whether the market can continue to stabilize remains uncertain. More seriously, Japan has very few policy tools available to deal with market fluctuations. Yukio Edano, leader of the opposition party, the Constitutional Democratic Party, and a former official at the Ministry of Finance, proposed that Japan could suppress rising yields through government bond repurchases or reducing the issuance of new government bonds. As for the Bank of Japan, it could adjust its bond purchase reduction plan or initiate emergency bond purchases - the central bank has previously stated that these two measures are alternative tools to deal with extreme market fluctuations. However, two sources familiar with the decision-making process of the Bank of Japan revealed that the central bank has set a high threshold for market interventions. The reason is that expanding bond purchases goes against the current policy direction of the Bank of Japan, which is committed to steering the economy away from heavy reliance on extensive stimulus policies and shrinking its large balance sheet. Analysts generally believe that no matter what measures are taken, their effectiveness in stabilizing the market will be limited. This is because the root cause of the current market volatility lies in investors' widespread concerns about politicians' loose fiscal policy proposals, which is a systemic crisis of confidence. Naoya Hasegawa, Chief Bond Strategist at Okasan Securities, said, "As long as the ruling coalition cannot come up with specific funding plans or expenditure reduction plans, and instead competes with the opposition parties to lower the consumption tax, the turmoil in Japan's bond market is unlikely to end."