‘Japan first’ electoral tide turns against Ishiba, LDP

TOKYO — Sunday’s upper-house election results were brutal for Japanese Prime Minister Shigeru Ishiba’s ruling Liberal Democratic Party (LDP). But they proved the “bond vigilantes” right as Tokyo’s fiscal trajectory is almost certain to shift toward budget-busting tax cuts.

Without a majority in either house of parliament, the LDP will have to cobble together a governing coalition to maintain power. That will require the LDP accepting lower taxes in return, particularly on consumption.

The election also shows that Japan is but the latest developed nation being upended by inflation and immigration. The former can be seen in surging rice prices and a 3.3% headline consumer price inflation rate, well above Tokyo’s 2% target. The latter in the “Japan first” Sanseito party emerging as a major force on Sunday.

This scenario had bond traders bidding up Japanese bond yields in recent weeks. Along with the inflationary fallout from US President Donald Trump’s tariffs, Tokyo is seeing bond punters refocus attention on its 260% debt-to-GDP ratio, by far the highest in the developed world.

On top of that, Japan faces one of the worst demographic trajectories anywhere: an aging, shrinking population that features one of the globe’s lowest birthrates. Any pivot back to aggressive fiscal loosening could make the volatility in Japanese markets seen in May look tame by comparison.

For now, Ishiba is digging in and claiming he’ll stay on as prime minister despite the LDP’s historic defeat. One factor working in his favor is a shallow bench of obvious replacements. But given that Ishiba’s approval ratings often wallow in the 20s, it’s hard to imagine him clinging to power for much longer.

This could alter the calculus for the Trump administration, which is increasingly desperate for another US-Japan trade deal. Trump 2.0 arrived believing Japan would be the easiest bilateral deal of all, a quick win for the “art-of-the-deal” president. Ishiba shocked Trump World by slow-walking the process and even asking what concessions the US might offer.

Tokyo politicos were perplexed by US Treasury Secretary Scott Bessent’s presence in Japan last Friday (July 18). Most figured he was trying to rush a bilateral trade deal into reality before Washington has to restart negotiations with a new Japanese government.

Yet even if Ishiba’s government can survive, its latitude to make major concessions to Trump may be less today than when he shook Bessent’s hand on Friday. That could put Japan even more in harm’s way if Trump decides to increase the 25% tariff he’s earmarked for Tokyo. It would be on top of a 25% tax on auto imports to the US, one already wreaking havoc for Asia’s second-biggest economy.

The trouble is that Japan’s economy is not in a good place regardless of Trump’s tariffs. In the first quarter, even before the worst of Trump’s biggest taxes on China and beyond, Japan contracted 0.2% in the first quarter and the slowdown probably deepened in the April-June period.

As Tokyo politics descend into disarray, it’s an open question how Ishiba, or the premier to be named later, handles the Trump challenge. Indeed, making a deal to placate Trump World just became harder. Yet the tariffs Trump is sure to throw Tokyo’s way could tip the economy into a painful recession.

And what about China? The LDP is watching on as Trump pivots back to seeking a “grand bargain” trade deal with Xi Jinping’s government. The New York Times reports that Trump’s Commerce Secretary Howard Lutnick has set off a bidding war of sorts among CEOs looking for a seat on Air Force One for a China visit soon.

Ishiba’s Japan might now have to contend with one of its biggest fears – that the real prize for Trump is a “grand bargain” trade deal with China. This might sound like good news for Japan if it avoids the financial carnage sure to come with a new trade war. But a US-China deal might leave Tokyo and Japan Inc’s biggest companies on the outside looking in.

Adding to the challenge is that both of the traditional policy levers Tokyo would normally employ are less available at present. The Bank of Japan, for example, has been raising interest rates for 12 months now. The current inflation rate suggests more tightening moves are needed.

That is, if not for the recession risks that Japan’s US$4.2 trillion economy now faces. Also, if not for the extreme bond market turmoil that rocked Japan in May. That turmoil may be about to return as the odds of fiscal loosening via tax cuts increase in Tokyo.

Ostensibly, the surge in Japanese government bond yields was a side effect of the chaos that Trump tariffs unleashed in US Treasuries. Yet it was also a matter of the bond vigilantes refocusing attention on Tokyo’s crushing debt load.

Trump 2.0’s import taxes triggered near-unprecedented turmoil first in US Treasury securities and then in debt markets everywhere. The volatility culminated in mid-May when a 20-year Japanese bond auction flopped with global investors.

The typically routine sale of $6.9 billion issues maturing in 2045 drew the least interest since 2012. The “tail,” or gap between the average and lowest-accepted prices, was the worst since 1987.

Suddenly, #JGBCrash was trending on social media. It was Tokyo returning the favor, sending shockwaves back toward the US. At the time, Bessent said worries about Japan were indeed pushing US yields higher.

Some argue Japan worries are much ado about nothing. For example, Japanese Finance Minister Katsunobu Kato’s team managed to tame markets by signaling a shift in bond issuance toward shorter-dated securities.

It helps explain why a less-than-stellar 40-year bond sale in late May didn’t slam world markets. Markets are betting that, for now, Tokyo is on top of things.

Masahiko Loo, senior strategist at State Street Global Advisors, argues that Japan’s volatility issues “are largely addressable through adjustments in issuance volume or composition.”

Loo adds that “we believe the concern on loss of control over the super-long end is overblown. 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 third quarter.”

Yet risks abound. In a note to clients, Macquarie Bank analysts warn that rising JGB yields could be a “trigger point” that catalyzes a wave of capital repatriation with Japanese investors pulling funds from dollar assets.

There’s also a risk of upsetting the so-called “yen-carry trade.” Twenty-six years of near-zero rates turned Japan into the top creditor nation. Investors everywhere made it standard practice to borrow cheaply in yen to bet on higher-yielding assets from New York to Sao Paulo to Seoul.

That’s why the slightest plunge or rally in the yen can send shockwaves through asset markets around the world. This creates a fresh dilemma for BOJ Governor Kazuo Ueda, should sudden yen gyrations challenge his ability to tame longer-term bond yields.

No one knows if Team Ueda might make good on its hawkish rhetoric earlier this year. But now that Trump’s tariffs are hitting Japan, it’s highly likely that the BOJ will become even more reluctant to tighten for fear of a yen surge unnerving Asia’s No 2 economy. The last thing the BOJ wants is to be blamed for a recession.

Yet the trade war, coupled with Japanese rate volatility, is bad news on a number of levels. Not least of which is that 2025 was supposed to be the year Japan’s long-awaited virtuous cycle finally arrived to hasten consumer spending and broader GDP growth.

In spring 2024, unions scored the biggest wage increase in 33 years — 5.28%. By year-end, though, the increase failed to materialize. Wages ended 2024 essentially flat. Then came Trump’s trade war, which is making wage gains even less likely. Might wage cuts now be the question?

The 25% import tax that Trump just slapped on Japan, effective in August, and his 25% auto tariff will be devastating to Japan Inc.

“If the high tariffs persist, negative effects on exports and capital investment will be unavoidable,” says Takeshi Yamaguchi, chief Japan economist at Morgan Stanley MUFG.

An immediate loser is the BOJ, which spent the last year working to normalize interest rates. That, adds Stefan Angrick, senior economist at Moody’s Analytics, complicates the BOJ’s way forward. “With wage growth stumbling and inflation proving sticky, the BOJ’s job will get much harder,” Angrick says.

Yet things are getting more complicated in Japan, socioeconomically speaking, as its version of Trump’s #MAGA party gains rising popular support.

Sunday’s election shows, Angrick notes, that “established opposition parties are increasingly eclipsed by the far-right, populist Sanseito party, which has capitalized on public anger over the economy to push strident anti-foreign rhetoric. That rhetoric has struck a chord, as more and more ordinary citizens are priced out of housing and services while foreign investors snap up real estate and record numbers of tourists flood the country.”

Unlike elsewhere in Asia, Angrick says, “foreign property buyers face almost no restrictions in Japan. This grates when housing prices have surged to multi-decade highs and tourists can claim refunds on the very consumption tax at the heart of this campaign. Future governments would do well to take note.”

Coupled with how rising inflation is reducing living standards, these anti-immigration currents put Japan in league with similar backlash in the US and Europe. They make the road ahead for Ishiba, or his successor, increasingly uncertain and treacherous.