Japanese love the new prime minister. Markets don’t.

Japan has cast off lost decades of deflation to join the rest of the developed world in modest inflation, currently running near 3%. That has been good for stocks, as companies recovered long-lost pricing power and banks could earn net interest margin.

Ordinary Japanese worry about their incomes keeping pace. “Real disposable income has hovered around zero in recent years," says Shigeto Nagai, head of Japan economics at Oxford Economics.

That angst was a big reason why 64-year-old Sanae Takaichi surged from dark horse to Japan’s first female prime minister in October. She has flipped the script with strategically targeted spending hikes and tax cuts, plus some tough talk toward China. Her approval ratings are near 70% while investors turn glum.

The iShares MSCI Japan exchange-traded fund is flat since Takaichi became Liberal Democratic Party leader on Oct. 4. It soared more than 20% over the previous nine months.

“The Japanese market looks fully valued," says Alex Wolf, global head of macro and fixed-income strategy at J.P. Morgan Private Bank. “We are neutral."

The fixed-income front is more alarming. Yields on 10-year Japanese sovereign bonds have climbed nearly half a percentage point to 2.12% on Takaichi’s watch. The yen, which should in theory rise with higher bond returns, has lost 6% against the dollar.

“The yen is stuck below its long-range fair value," says Aaron Hurd, senior currency portfolio manager at State Street Global Advisors. “I don’t see a catalyst for a rally except some big global risk-off event."

Investors felt relaxed about Japan’s world-leading government debt—well over 200% of gross domestic product—so long as it paid no interest on it. If rates keep climbing, the fiscal noose might tighten.

“Japan is one of the leading candidates in the world for a debt shock," Nagai warns.

No one is pushing a panic button just yet, though. Unlike the United Kingdom, where so-called bond vigilantes forced Prime Minister Liz Truss out of office after seven weeks in 2022, Japan is a massive creditor nation, with net foreign assets of $3.7 trillion, according to Kyodo News. “In extremis, domestic investors can repatriate capital to cover Japan’s debt," says Nick Verdi, a global rates and FX strategist at TCW.

Takaichi’s fiscal splurge has been as much hoopla as substance, with crowd-pleasing measures like increasing income tax deductions and abolishing the gasoline tax. Higher inflation-driven revenue may keep debt-to-GDP stable. Bond issuance hasn’t increased in her first 100 days.

“Her policies have come out better than people were expecting in October-November," Hurd says.

Luck may be on Takaichi’s side in 2026. Verdi sees inflation subsiding toward 2% as an initial jolt to food prices wears off. Oil prices that have dropped by a quarter over the past year should slash import bills.

Wages are looking up, with unions demanding a 5% hike in spring negotiations that set the bar for everyone else. Federal Reserve cuts and further inching upward by the Bank of Japan should reduce the interest-rate gap, pulling Japanese capital back home and bolstering the yen.

“I think we get to 140 later this year," Hurd predicts. A dollar is currently worth 157 yen. All that means Takaichi and the BoJ have a chance to steer post-deflation Japan onto a stable growth path, not that they will. “We think it’s too early to neutralize our underweight Japanese bond exposure," TCW’s Verdi says.

Markets are watching and waiting for now.