Prospects for a trillion-dollar Japanese government fiscal spending program have profoundly disrupted the trajectory of the AI-fueled super-bull market in Japanese stocks and unsettled the bond and foreign exchange markets. This caused the yield on Japan's 10-year government bond to surge to 2.85% on Wednesday, reaching its highest level since 1996. However, for now, this has not altered the relatively positive outlook of one of the three major international credit rating agencies, Moody's Ratings. Moody's has maintained its latest stance of an "A1" rating with a "stable" outlook for Japan. In the short term, this is equivalent to "no new downgrade shock" for the Japanese government bond (JGB) market, but it does not mean that pressure on the bond market has been lifted.

The yield on Japan's 10-year government bond has risen to approximately 2.865%–2.88%, hitting a multi-decade high, and the 30-year yield has also climbed past 4%. This indicates that market trading is not primarily driven by the risk of a rating adjustment, but rather by the combined forces of fiscal expansion, persistent inflation, a weak yen, and the Bank of Japan's tapering of bond purchases, all of which are pushing up term premiums. Moody's latest position reflects its continued recognition of Japan's stable growth, nominal GDP expansion from sustained inflation, and the potential for a gradual decline in its debt-to-GDP ratio. However, if the 370 trillion yen ($2.3 trillion) 14-year long-term investment plan, championed by the government of Prime Minister Kishi, lacks a clear source of funding, the bond market will still demand higher risk compensation.

If Japanese government bond yields continue to rise and breach key market psychological thresholds, and this is compounded by sustained yen weakness triggering larger-scale foreign sell-offs, the denominator in the discounted cash flow (DCF) valuation models for the Japanese stock market—which has repeatedly hit record highs this year—will be elevated. This would put the most pressure on the growth stocks and high-valuation AI and semiconductor theme sectors that have driven the market's super-bull run. Conversely, sectors like banks, insurance, value stocks, and financials that benefit from rising nominal interest rates may continue to perform relatively better. In other words, Moody's stable rating for Japan represents a "delayed risk repricing" for the stock market, not a "cancellation of risk repricing."

Since the beginning of this year, the Japanese stock market has become completely decoupled from the government bond market and the yen exchange rate. Foreign capital has continued to pour in on a large scale, propelling the stock market to dazzling heights and repeated new records, while government bonds and the yen have suffered. Hot stocks with significant weight in the Nikkei 225, such as Kioxia, SoftBank, Socionext, Advantest, Tokyo Electron, Lasertec, Disco, Murata, and Taiyo Yuden—which are primarily in the AI chip and semiconductor equipment sectors closely tied to AI computing infrastructure—have been the central "narrative axis" for the recent massive, continuous foreign inflows and the core contributors to the Nikkei 225's record-breaking gains.

Martin Petch, Vice President of the Sovereign Risk Group at the credit rating agency, did not sound an alarm over Japan's fiscal spending and debt expansion trajectory, but he did note that the massive 370 trillion yen ($2.3 trillion) investment plan over 14 years proposed by Prime Minister Kishi requires clearer explanation. In a media interview on Wednesday, Petch stated, "At this stage, we think the credit rating is fairly stable." Moody's assigns Japan an A1 credit rating, its fifth-highest investment grade, with a "stable" outlook. "Risks remain very balanced," Petch added.

While Moody's has temporarily maintained Japan's A1 rating and stable outlook, the yield on Japan's 10-year government bond has risen to around 2.87%, reaching its highest level since 1996. The market appears to be truly trading on a stress test of fiscal credibility, driven by the government's 370 trillion yen/$2.3 trillion long-term investment plan, yen weakness, inflation expectations, and potential Bank of Japan rate hikes. Several unknowns remain regarding this enormous trillion-dollar-scale plan. The plan aims to channel public and private funds into 17 priority areas, including artificial intelligence and semiconductor manufacturing, a sector Japan has largely retreated from in recent decades.

Petch noted it is unclear whether Japan possesses significant comparative advantages in all these target industries and whether the country can attract sufficiently large-scale foreign investment and private sector capital. Given its long time horizon, Petch also expressed skepticism about whether this strategy can be sustained across future governments. However, he added that the investment plan could also have a significantly positive impact on the country's credit profile.

Petch's comments come as investors are trying to assess the impact of the massive spending plan championed by the Kishi government and the extent to which she seeks to influence the monetary policy path of the Bank of Japan. Since the plan's announcement last month, yields on long-term Japanese government bonds have continued to climb, reaching multi-decade highs, while the yen exchange rate remains near its lowest level in nearly 40 years.

The greatest uncertainty surrounding this investment plan may stem from the lack of a clear funding source. Although this poses significant risks to Japan's stock, bond, and currency markets, and even global financial markets, Petch stated it is too early for Moody's to draw conclusions for its credit assessment. "Our view on the rating will evolve," Petch said, also noting that government plans can change through what is known as a "policy reaction function"—the tendency of officials to recalibrate policy when market concerns are reflected in higher borrowing costs or capital flows.

This function was on full display this week. A draft of the government's annual economic policy agenda spooked financial markets by giving the impression that the Kishi government was pressuring the Bank of Japan to slow the pace of interest rate hikes. In response, officials adjusted the language concerning monetary policy in an updated version.

Currently, Petch and his team are focusing on factors they believe support the credit profile: Japan's stable economic growth trajectory, sustained long-term inflation, and progress in reducing the debt-to-GDP ratio. According to a research report dated July 8th, their projections show this ratio declining from a peak of about 219% in fiscal year 2020 to below 195% by 2030.

On the other hand, Petch pointed out that an aging population and a significant rise in defense spending pose longer-term financial market risks. The rating representative also stated that the likelihood of a rating downgrade would increase significantly if the government clearly deviates from fiscal consolidation. A potential warning sign would be the government focusing more on recurrent spending aimed at supporting short-term economic growth rather than measures consistent with long-term fiscal discipline.

Investors are increasingly beginning to worry that such a shift may have already started. The government's latest policy draft removed the classic phrase "fiscal consolidation"—a term that had appeared in versions up to 2025. The market views this as an indication of a weakened commitment to fiscal discipline.

Petch also downplayed concerns that the Japanese government bond market might struggle to absorb debt issuance as the Bank of Japan continues to taper its JGB purchases. "We do see fiscal consolidation continuing along a modest path, and then the pressure should be manageable," Petch said.

The core implication of Moody's temporary maintenance of Japan's A1 rating and stable outlook is not that "Japan's fiscal risks have disappeared," but rather that the rating agency still views Japan's nominal growth, sustained inflation, and slowly declining debt-to-GDP ratio as sufficient credit buffers to offset the short-term shock of fiscal expansion. What truly makes the market nervous is the policy mix itself: the Kishi government has proposed a 14-year, roughly 370 trillion yen/$2.3 trillion long-term investment plan covering 17 priority industries including AI and semiconductors; meanwhile, the Bank of Japan has raised its policy rate to around 1%, and the government's policy draft was initially interpreted by the market as an attempt to influence the central bank's rate hike pace, later requiring adjusted wording to ease concerns about central bank independence.

The rise in Japan's 10-year government bond yield to around 2.865%–2.88%, a multi-decade high, and the 30-year yield surpassing 4%, indicates that the bond market is trading on the question of "whether fiscal expansion can be credibly financed," not simply whether the rating will be downgraded. The destructive power of this large-scale sell-off in Japanese bonds lies in its stress test of Japan's long-relied-upon low-interest-rate fiscal model. Japan's government debt exceeds 200% of GDP, and the implicit premise of its past sustainability was low inflation, low interest rates, and the central bank continuously absorbing bond supply. However, when a weak yen drives up import inflation, the market demands a higher term premium, and the central bank is compelled to pursue normalization, the rise in long-term Japanese government bond yields is no longer a "benefit of economic recovery" but more akin to a "fiscal risk discount."

This also explains why the yield rise has not effectively supported the yen: if the interest rate increase stems from risk and term premiums rather than healthy rate hike expectations, the foreign exchange market instead worries about fiscal dominance, policy constraints, and sticky inflation, creating a negative feedback loop of "falling JGBs – weak yen – rising inflation expectations – a harder balancing act for the central bank."

For the Japanese stock market and the AI-fueled super-bull run driving its rally, the real risk is not valuation itself, but a marginal reversal in the capital structure. The Nikkei's recent surge has significantly benefited from expanding demand around the AI computing supply chain, the export advantage from a weak yen, corporate governance reforms, and foreign capital inflows. The Nikkei 225, the blue-chip benchmark, has gained about 35% year-to-date, significantly outperforming major indices in the US, Europe, and China. Foreign investors were still net buyers of Japanese stocks to the tune of 1.08 trillion yen in the week ending May 23rd, marking the eighth consecutive week of net inflows.

However, for investors focused on the Japanese stock market, the core issue is that the AI semiconductor theme itself is already highly dependent on foreign capital pricing. If long-term interest rates continue to rise, yen volatility intensifies, and the crowded global AI semiconductor trade and leveraged positions cool significantly, foreign capital could shift from being "marginal buyers" to "marginal sellers." This could replicate the dangerous structure seen in the later stages of the dot-com bubble, where "institutions exit first, and domestic funds passively take over."

The Japanese stock market has recently seen its largest single-week foreign selling since March, precisely due to soaring long-term JGB yields, the yen depreciating to a 40-year low, profit-taking in extremely crowded and highly leveraged tech stocks, and rising valuation concerns around AI semiconductors. This is more concerning than simply discussing price-to-earnings ratios. If the Kishi government can provide a clear source of funding, maintain language on fiscal consolidation, and ensure the Bank of Japan has policy space to combat inflation, the Japanese stock market may still be supported by AI semiconductors, capital expenditure, financial stocks, and export leaders. However, if the 10-year yield continues to approach or breach 3%, and foreign investors become continuous net sellers of Japanese tech and semiconductor assets, high-valuation sectors of the Japanese stock market will face a dual squeeze from discount rates and capital flows, potentially even experiencing sharp bear-market declines reminiscent of the dot-com bubble era around 2000.