Japan's Fiscal Policy Risks 'Truss Shock' Selloff

Japan is on the brink of facing market turmoil over its fiscal policy, with a former top currency diplomat warning that further tax relief could trigger a selloff in government bonds and the yen similar to the UK's "Truss shock."

Hiroshi Watanabe, a former vice finance minister for international affairs, stated that markets remain highly sensitive to any moves by the ruling Liberal Democratic Party (LDP) to expand sales tax cuts to secure voter support.

"We're somehow managing to hold the line for now, but it's right at the edge," Watanabe said in an interview. Watanabe, now a visiting professor at Tokyo Seitoku University, was in charge of Japan's currency policy from 2004 to 2007.

Election Pledges Raise Fiscal Alarms

The warning comes as Prime Minister Sanae Takaichi seeks a new mandate for her economic reflation strategy in a snap election scheduled for February 8.

Investors are watching closely for any sign that the LDP might lean toward more tax cuts if the election campaign proves challenging. This political pressure is reviving concerns about fiscal discipline in a country where public debt is more than double the size of its economy.

A market rout last month provided a stark example after Takaichi pledged to cut the consumption tax on food for two years. The announcement triggered a sharp selloff in super-long Japanese government bonds and pushed the yen toward levels that had previously prompted government intervention.

Market Reaction and Government Response

Markets have stabilized since then, with the yen recovering to around 154 per dollar. This rebound followed speculation that Japanese and U.S. authorities conducted rate checks, a move often seen as a precursor to direct currency intervention.

Watanabe believes that top officials have taken note of the market's negative reaction. "I do think that Takaichi, as well as Finance Minister Satsuki Katayama, have registered the warnings coming from global capital markets," he said, suggesting that caution from U.S. and European investors has likely influenced policymakers' public statements.

However, he cautioned that investors would react strongly to any hint that tax relief could be expanded beyond the current pledges.

Headwinds Cloud the Yen's Outlook

Looking ahead, Watanabe sees limited potential for a sustained recovery in the yen. While he noted that "there is a possibility that the yen could briefly move into the 140s per dollar," he does not foresee a prolonged period of appreciation.

Several key factors are expected to weigh on the Japanese currency:

• Persistent concerns over Japan's public finances.

• The country's structural trade deficit.

• A lack of clarity regarding the Bank of Japan's future interest rate path.

These combined pressures make it difficult to envision a scenario where "yen appreciation continues" for an extended period.