Japan Prime Minister Takaichi must face bond investors before winning over voters

Japanese Prime Minister Sanae Takaichi faces a crucial markets test in the final run-up to a snap election this weekend where she is hoping a decisive victory will give her a mandate for expansionary fiscal policy.

The finance ministry will auction some 700 billion yen ($4.5 billion) of 30-year government bonds on Thursday, three days before polls open.

It's a tenor that has been hyper-sensitive to worries about a loosening of fiscal restraint, suffering a rout last month as investors balked at Takaichi's pledge to suspend the consumption tax on food.

Auctions have been a particular flashpoint for investors expressing concern about the state of Japan's finances, which are the worst in the developed world with debt totalling 230% of GDP.

In four of the past five 30-year bond sales, yields spiked to fresh record highs either in the run-up to or immediately following the auction results.

That includes the sharp selloff on October 7, which came just three days after Takaichi - known as a fiscal dove and acolyte of the "Abenomics" policies of late premier Shinzo Abe - won the ruling Liberal Democratic Party's leadership contest, setting her up to become prime minister.

Bond yields move inversely to prices.

"This auction essentially serves as a referendum on how investors feel about the fiscal risks from the election," said Shoki Omori, chief desk strategist at Mizuho Securities.

"I would say demand at the auction is likely to be on the weak side, because investors are going to be cautious. And they have a right to be," Omori added, suggesting that yields could spike after the auction.

The worries are evident in the term premium - the compensation investors demand for holding bonds over a longer time span. Omori said he calculates the 30-year term premium stands at 2.8 percentage points, "way steeper" than the 1.6 percentage points for 10-year JGBs.

This will be the first 30-year debt sale since Takaichi called the snap election on January 19 and pledged the sales tax suspension - and bond markets are likely to be on edge after the latest newspaper polls suggested her LDP is poised for a landslide victory.

An auction of 10-year notes on Tuesday will offer an even earlier indication of investor appetite for government debt, although the tenor is more liquid and draws a wider range of investors so tends to be less volatile.

The benchmark 30-year JGB yield JP30YTN=JBTC hovered at 3.63% on Monday - down from the record high of 3.46% on January 20, but still up about half a percentage point from where it was at the start of October.

Japan's sovereign bond market is overwhelmingly funded by domestic investors and not at real risk of capital flight.

However, offshore accounts - predominantly hedge funds - are playing a bigger role in Japan's longest-dated bonds, exacerbating volatility in the historically docile market as they fill the void left by traditional buyers such as life insurers and pension funds.

Foreign investors accounted for about 46% of trading in super-long cash JGBs in December last year, the most recent data from the Japan Securities Dealers Association show, up from 13% a year earlier.

"At the super-long end, it's not real money investors in there. It's fast money," said Chris Scicluna, head of research at Daiwa Capital Markets Europe, adding that the persistent slide in prices was keeping Japanese buy-and-hold investors sidelined.

"When you've seen such significant volatility, you don't want to be the one to try and catch a falling knife."

($1 = 154.8600 yen)

-Kevin Buckland/Reuters