In a historic shift, Japan's first female Prime Minister, Sanae Takaichi, has captured the nation's affection with bold economic policies aimed at tackling the cost of living. However, this domestic popularity stands in stark contrast to the growing unease in financial markets, which are watching Japan's fiscal path and currency with a wary eye.
The Popularity Surge Amid Economic Anxiety
Japan has finally escaped its long battle with deflation, joining other developed nations with an inflation rate hovering near 3%. While this has boosted corporate profits and bank margins, it has squeezed household budgets. Real disposable income has stagnated near zero in recent years, according to Shigeto Nagai of Oxford Economics. This widespread anxiety over affordability became the catalyst for Sanae Takaichi's remarkable rise from political dark horse to the nation's leader in October 2025.
The 64-year-old leader has responded with a mix of targeted spending increases, tax cuts—including popular moves like raising income tax deductions and scrapping the gasoline tax—and a firmer stance on China. This recipe has resonated deeply, pushing her approval ratings to an impressive near 70%.
Market Jitters and the Fiscal Balancing Act
While the public cheers, investors have turned cautious. The iShares MSCI Japan ETF has shown no growth since Takaichi assumed leadership of the Liberal Democratic Party on October 4, 2025, a stark contrast to its over 20% surge in the preceding nine months. Analysts like Alex Wolf of J.P. Morgan Private Bank note the market appears "fully valued," prompting a neutral stance.
The fixed-income scene is more concerning. Under Takaichi's watch, yields on 10-year Japanese government bonds have jumped nearly half a percentage point to 2.12%. Paradoxically, the yen has not strengthened with these higher returns, instead depreciating by 6% against the US dollar. Aaron Hurd of State Street Global Advisors observes the currency remains below its fair value, lacking a clear catalyst for recovery.
These moves spotlight Japan's colossal public debt, which exceeds 200% of GDP. The situation was manageable when debt carried near-zero interest, but rising rates threaten to tighten the fiscal noose. Nagai warns that Japan is a leading candidate for a potential debt shock globally.
A Cushion of Capital and a Path Forward
Yet, panic is not imminent. Unlike the UK's 2022 bond market crisis, Japan is a massive creditor nation, with net foreign assets of $3.7 trillion. Nick Verdi of TCW points out that in a crisis, domestic investors could repatriate vast sums to cover obligations.
There are also positive signs. Takaichi's stimulus, while headline-grabbing, hasn't yet increased bond issuance in her first 100 days. Higher inflation-driven tax revenues might help stabilise the debt-to-GDP ratio. Hurd notes her policies have "come out better than people were expecting."
Looking ahead to 2026, several factors could align in Takaichi's favour. Inflation is expected to ease toward 2% as food price shocks fade. A 25% drop in oil prices over the past year should reduce import costs. Crucially, spring wage negotiations are targeting 5% hikes, which could finally boost consumer spending power.
Furthermore, anticipated interest rate cuts by the US Federal Reserve and gradual hikes by the Bank of Japan could narrow the rate gap, potentially pulling capital back to Japan and strengthening the yen. Hurd predicts the dollar could fall to 140 yen later in 2026 from the current level of 157.
This confluence of events presents Prime Minister Takaichi and the Bank of Japan with a critical opportunity to guide post-deflation Japan onto a path of stable, sustainable growth. However, the task is fraught with risk. As TCW's Verdi states, it's still "too early to neutralise" an underweight position on Japanese bonds. For now, the world's markets are intently watching and waiting to see if Japan's popular leader can also become a champion of economic stability.
