Following Takachiho's election victory last Sunday, Japanese stocks have repeatedly hit record highs this week, with the Nikkei 225 index climbing a cumulative 5%. However, behind this market frenzy, dubbed the "Takachiho Trade," some investors are growing concerned it may be transforming into a trap. Certain traders have even warned that the current market calm could be the "calm before the storm."

Despite the stock market's exuberance, Japan's bond and currency markets have displayed relative calm, a stark contrast to the pre-election period. Markets had previously experienced significant volatility due to concerns over Takachiho's aggressive fiscal spending plans. The current disconnect between stock and bond markets suggests that some investors appear to believe the new Prime Minister, despite her increased political mandate, will exercise restraint when implementing her fiscal agenda.

Core risks, however, persist. Analysts warn of a potential "Takachiho Trap" for Japanese markets: if the new Prime Minister significantly increases public spending to fulfill promises of addressing cost-of-living issues, it could further weaken the yen. This, in turn, could exacerbate inflation by raising the cost of imports like energy, ultimately negatively impacting stock performance.

Takachiho is currently attempting to reassure markets, claiming her campaign remarks regarding the yen were "misunderstood" and pledging that her plan to cut consumption tax will not involve issuing new bonds. Wall Street strategists remain skeptical, questioning how she can deliver on fiscal promises without disrupting markets, given her substantial popular mandate.

The Calm Before the Storm Despite the Nikkei 225's 5% weekly gain, a Tokyo-based trader noted that the reaction in Japanese Government Bonds and the yen market has been far calmer than pre-election expectations. The trader cautioned, "We should probably view this as a temporary phenomenon, because the core issue is how she will pay for it. This isn't a honeymoon period; it feels more like the calm before the storm."

The relationship between Takachiho and the bond and currency markets has been tense since she unveiled a fiscal spending plan worth $135 billion last November. To capitalize on her popularity during the election, she previously pledged a two-year suspension of the food consumption tax, a measure estimated to cost ¥5 trillion (approximately $32 billion). In anticipation, the yield on Japan's 40-year government bond briefly surpassed 4%, and the yen weakened.

Her absolute majority in the lower house now provides a solid political foundation for implementing these spending commitments, which is precisely the source of market anxiety.

The Currency Trap and the Central Bank's Dilemma Darren Tay, Head of Asia-Pacific Country Risk at BMI, highlighted the risk of a "Takachiho Trap" for the yen. Higher government spending increases the risk of currency depreciation. With the yen hovering around 153 against the US dollar, Takachiho has relied on her Finance Minister, Akira Katayama, to soothe markets, with officials issuing verbal warnings hinting at potential intervention.

Osamu Takashima, a FX strategist at Citi, suggested that government intervention in the market would occur if the yen weakened towards 160. This places the Bank of Japan in a difficult position. While markets expect the BOJ to implement at least two interest rate hikes by 2026, some traders worry the central bank might face pressure to delay tightening to allow Takachiho more room for fiscal action. One trader stated bluntly that any intervention under conditions of sustained BOJ easing would effectively amount to a "temporary subsidy for short sellers."

Doubts Over Fiscal Promises In an effort to ease tensions with financial markets, Takachiho stated in her first post-election press conference that her consumption tax cut plan would not involve issuing new bonds. Analysts, however, are skeptical.

Benjamin Shatil, Senior Economist at J.P. Morgan, questioned, "Given the scale of her mandate, how can she realistically walk back such a promise? Unlike other prime ministers, she cannot use parliamentary gridlock as an excuse."

Furthermore, Shusuke Yamada, Head of Japan FX and Rates Strategy at Bank of America, believes the election did not alter the structural drivers of yen weakness. He noted that companies and investors will continue seeking returns outside of Japan's aging, slow-growth economy, and a reversal of the yen carry trade is unlikely in the short term. He emphasized, "They need to see concrete evidence that Japan is a better place for long-term investment... that takes years."

Debt Concerns and Market Divergence Concerns about Japan's fiscal health are rooted in its substantial public debt. According to IMF data, Japan's gross public debt stands at 237% of GDP.

The market is significantly divided on this risk. Nicholas Smith, an analyst at CLSA, argues that these concerns primarily reflect the view of foreign investors, who hold only 6.6% of Japanese Government Bonds but account for 71% of futures trading volume. Smith suggested foreign investors "have no skin in the game, and all indications are they don't really understand this market," pointing out that Japan's net debt position is significantly lower than its gross debt and is projected to decline further in coming years.

Others, however, believe the government should be more vigilant. BMI's Darren Tay warned that markets might be underestimating the populist pressures on Takachiho, and the perception that Japan's debt is mostly domestically held could give the government a "dangerous sense of insulation," causing it to ignore warning signals from global bond markets.

Takahide Kiuchi, an economist at the Nomura Research Institute, also stated that while the debt level itself isn't necessarily the problem, he had "never experienced a situation where long-term yields rose so sharply over such a prolonged period as they did before the election." He warned that the Japanese government needs to respond to these warning signals, or the country could face a crisis.