Structural Risks in JGBs: Why the Election Outcome Could Trigger a Sustained Sell-Off

Japan's bond market is at a crossroads. With the upper house election approaching in July 2025 and opposition parties vowing to overhaul fiscal policy, investors face an escalating risk of a sustained sell-off in Japanese Government Bonds (JGBs). The stakes could not be higher: Japan's public debt-to-GDP ratio of 250%—the highest among major economies—already strains the limits of financial stability. Add to this a cocktail of tax-cut proposals, political uncertainty, and structural flaws in Japan's fiscal framework, and the stage is set for a re-pricing of risk that could reshape global markets.

The Fiscal Tightrope: Tax Cuts vs. Debt Dynamics

Opposition parties like the Constitutional Democratic Party (CDP) and the Japan Innovation Party (JIP) are pushing for sweeping fiscal changes. Foremost among these is a reduction—or outright elimination—of the 10% sales tax, which contributes 21.6% of government revenue. The CDP's plan to halve the sales tax would create an annual revenue shortfall of over ¥10 trillion, while the Sanseito party's proposal to abolish it entirely enjoys 68% voter support. Such measures, while politically popular, would force Japan to rely even more heavily on debt issuance.

Meanwhile, opposition calls for expanded fiscal stimulus—including cash payouts to households—threaten to deepen the deficit. Barclays estimates that if the ruling coalition falters, supplementary budgets could exceed ¥10 trillion, requiring further borrowing. With Japan's debt already at unsustainable levels, even modest fiscal slippage risks triggering a loss of market confidence.

Bond Market Pressures: Yields at Multi-Decade Peaks

The market is already pricing in these risks. The 10-year JGB yield has surged to 1.6%, the highest since the 2008 financial crisis, while the 30-year yield has breached 3.2%—near its May 2025 peak. Super-long-dated bonds, such as the 40-year JGB, have seen yields hit 3.689%, levels not seen in decades. Barclays attributes this to fears that opposition fiscal policies will exacerbate deficits, with a three-percentage-point sales tax cut already priced into long-dated yields.

The Bank of Japan (BOJ) faces a dilemma. Its yield curve control (YCC) policy, which caps long-term yields, has kept borrowing costs artificially low. Yet political pressures to maintain low rates clash with the need to address fiscal imbalances. A shift in leadership—such as a potential BOJ governor from a pro-stimulus faction—could destabilize this fragile equilibrium.

Lessons from the UK: Fiscal Credibility and Market Discipline

The UK's 2022 fiscal crisis offers a cautionary parallel. Then-Prime Minister Liz Truss's mini-budget—featuring unfunded tax cuts and spending hikes—triggered a bond market rout, with 10-year gilt yields spiking to 4.9%. Markets forced a policy U-turn, underscoring the fragility of fiscal credibility. While Japan's situation differs—its debt is domestic, and the BOJ's YCC has delayed discipline—the parallels are stark.

Japan's reliance on domestic buyers (e.g., life insurers, pension funds) has shielded it from external market discipline for decades. But demand for long-dated bonds is waning, with insurers reducing JGB holdings due to negative yields. The Ministry of Finance's efforts to shrink long-dated issuance have done little to ease supply-demand imbalances. A political shift post-election could finally break this cycle, forcing yields higher and exposing Japan to global capital outflows.

Structural Risks: Beyond the Election Cycle

The risks are not merely political. Japan's aging population and stagnant growth mean tax revenues are unlikely to rebound meaningfully. Structural reforms—such as immigration liberalization or tax base broadening—are politically toxic but fiscally essential. Without them, Japan's debt trajectory becomes a “death spiral,” where rising yields force more borrowing, further raising costs.

Analysts at Barclays warn that even a minor opposition victory could tilt fiscal policy toward expansion, permanently re-pricing JGBs. A “steepener trade”—betting on widening yield curves—could profit from this. Short positions in super-long JGBs or underweight allocations to JGB ETFs (e.g., JGB Index Funds) appear prudent.

Investment Implications: Positioning for the Unthinkable

Investors must treat JGBs as a high-risk asset class. Key considerations include:

1. Short-Term Volatility: Expect heightened JGB market swings ahead of the election. A ruling coalition defeat could send yields soaring further.
2. Long-Term Sustainability: Japan's debt burden is unsustainable without reforms. Even a 1% rise in interest rates would add ¥10 trillion to annual debt servicing costs.
3. Global Carry Trade Risks: Higher JGB yields could reverse Japan's “yen carry trade,” with capital repatriation pressuring global equities and commodities.

Conclusion: The Write-Off of Fiscal Comfort

The upper house election is not just a political contest—it's a referendum on Japan's fiscal future. Opposition parties' promises of tax cuts and stimulus may win votes, but they risk accelerating a sell-off in JGBs that could rival the UK's 2022 crisis. Investors should treat JGBs with caution: reduce exposure to long-dated maturities, hedge against yield curve steepening, and monitor political developments closely. In a world where debt is king, Japan's experiment with fiscal excess may finally meet its reckoning.

This analysis is for informational purposes only and should not be construed as personalized investment advice.