Japan

Takaichi-Era Stimulus

In the second half of 2026, investors are likely to focus on fiscal stimulus and monetary policy. The Liberal Democratic Party, led by Prime Minister Sanae Takaichi, won a landslide election in February based in part on an affordability platform calling for consumption tax reductions for food. Since then, Takaichi has tempered expectations for sizable fiscal stimulus, in part to reassure jittery bond markets that her government will not materially increase deficits. The Iran War complicated the government’s path, as energy subsidies to insulate consumers and companies from Iran-related price surges have come at a considerable cost.

In the Diet session that concludes in mid-July, the Takaichi administration is likely to propose extensions of fuel subsidies and price controls for electricity and gas rates to limit the inflationary shock for consumers. Including reductions to the consumption tax for food could be politically popular as well and could boost consumption marginally at the expense of larger fiscal deficits.

More Rate Hikes on the Way?

The Bank of Japan (BoJ) appears on course to further raise interest rates in the second half of 2026 (Exhibit 14), taking the uncollateralized call rate to 1.25% by year end. The rationale is clear: Japan’s CPI inflation exceeded 2% in 45 of the 49 months ended April 2026, and core-core inflation (ex-fresh food and energy) has been at or above 2% for 41 of the last 43 months. The Iran War has added upside risk to prices, reinforcing the BoJ’s tightening bias.

I anticipate that rising rates in Japan could contribute to strengthening of the Japanese yen against the US dollar and other currencies as expectations for monetary policy outside of Japan become more dovish in the second half of this year.

Why Japanese Bonds Matter

The TOPIX has been a standout performer since the beginning of 2025, rising 48.2% in US dollar terms through late June versus the S&P 500 Index, which has returned 28.8%. However, Japanese Government Bonds (JGBs) have been a different story, with the 10-year JGB yield rising to 2.7% from 1.1% and the 30-year yield up to 3.9% from 2.3% over the same period (Exhibit 15).

The implications for global capital flows are significant. For decades, JGBs offered one of the lowest yields globally due to Japan’s low inflation and low short-term interest rates. Over time, Japanese investors allocated more capital to overseas bond markets to capture higher yields. Typically, these investors bought foreign bonds on a currency unhedged basis, hoping to benefit from any yield weakening above and beyond the extra carry from higher interest rates.

As of the first quarter of 2026, Japanese investors were the largest owners of US Treasuries, holding $1.19 trillion out of $9.35 trillion held by non-US investors. If my expectations are correct, rising short-term interest rates combined with a strengthening Japanese yen could turn years of investing logic upside down for Japanese investors. Rather than benefiting from higher interest rates and a weakening yen, investors could find that they are getting a smaller yield pick-up from owning US Treasuries, and they could see the value of their holdings decline when translated back to their home currency.

If this happens for a sustained period, we could see a substantial repatriation of capital from the United States, and potentially other markets, back to Japan. Given the scale of fiscal deficits and the level of debt-to-GDP in other developed economies, rising JGB yields and term premia could raise debt sustainability concerns, fueling further curve steepening.

Elevated Tensions with China

Since November 2025, when Takaichi said that a Chinese attack on Taiwan could represent a “survival-threatening situation,” the relationship between Japan and China has deteriorated. The Chinese response was swift and sharp and included a range of diplomatic, trade, and cultural policy changes.

One example of the economic damage inflicted on Japan has been the decline in Chinese visitors. In August 2025, just over one million Chinese arrivals were recorded in Japan, with ~90% being tourists. March arrivals fell below 300,000, the lowest since October 2023 and well below typical seasonal levels. Over the same period, Beijing has imposed a seafood import ban on Japanese goods, halted agricultural trade talks, and limited cultural and academic exchanges.

While the China–Japan friction is unlikely to become dangerous, it is a reminder that Japan faces geopolitical and national security risks from its much larger neighbor. The threats are also more pressing given a less predictable partnership with the United States, which has been less supportive of Japan in this situation than in the past. All of this could lead to further significant increases in Japanese military spending in the years ahead.