By Leika Kihara and Tamiyuki Kihara
TOKYO, July 29 (Reuters) - Japanese Prime Minister Sanae Takaichi is fighting a losing battle in the polls, making a retreat from promised tax cuts more difficult and denying her officials the political backup they need to talk down yen and bond market bears.
Takaichi's approval rating slumped in July to the lowest since she took office last year as rising inflation, blamed in part on high import costs from a weak yen, hit her standing with voters.
The prime minister's strong advocacy of fiscal stimulus and harsh criticism of higher interest rates have heightened investor concerns about worsening public finances in Japan, sending bond yields higher.
Those bond market anxieties have also blunted official efforts to talk down speculative bets against the yen, government sources said.
"Markets are gaining control over fiscal management, which hasn't happened in Japan for decades," one of them said, warning about the danger of being at the mercy of bond vigilantes.
TALKING BOTH SIDES
Since becoming prime minister last year, Takaichi has sought to pursue a pro-growth agenda while also tempering investor concerns about fiscal discipline and central bank independence.
Those competing demands have created a communication challenge that has at times led to unwanted market volatility, which in turn makes policy implementation more difficult.
For example, her spending plans, aimed in part at easing rising household living costs, lifted bond yields to three-decade highs in July on concern over Japan's worsening finances.
Mindful of such market pressures, Takaichi told a news briefing on Monday the administration would seek to gain market trust in Japan's finances through transparent communication.
"I would say communication with markets would become more important," she said when asked what she could have done better.
But when pressed about her administration's sliding approval ratings, Takaichi stressed her determination to break Japan's "excessive fiscal tightening" with big investment, a sign she had no plans to back down on expansionist policy.
"The sliding approval ratings would only solidify the premier's determination to cut tax and boost investment," another source said. "Pursuing her policies would jolt markets, while not doing so would hit her popularity. It's a dilemma."
Those challenges could worsen ahead of a host of events that could ignite a renewed spike in yields.
Despite reservations voiced even within her ruling party, Takaichi is set to proceed with a plan to cut by two years an 8% levy on food, domestic media reported. While the move would come as little surprise, a lack of funding clarity could further upset bond markets, analysts say.
The government also plans to avoid setting caps on spending requests for key growth areas in an overhaul of budget drafting that could boost expenditure and debt issuance next fiscal year.
"Takaichi tried to explain how her administration was mindful of the need for fiscal discipline. But her policies themselves won't change much, so there's not much hope in bond markets that things could change," said Atsushi Takeda, chief economist at Itochu Research Institute.
"JGB yields have stabilised somewhat but that's because of falling oil prices. The premium markets are charging for Japan's fiscal situation hasn't changed," he said.
FACTS AND FIGURES NEEDED
While the government focuses on rising yields, Takaichi's dovish fiscal and monetary approach has also caused headaches in the currency market with the yen sliding to a four-decade low.
Although Finance Minister Satsuki Katayama's repeated threats of "decisive" action have kept markets on edge, they have failed to give a sustained boost to the sagging currency.
Top currency diplomat Atsushi Mimura, who decides how and when to intervene, has stayed quiet since the record $72 billion intervention conducted between late April and early May that did little to arrest the yen's downtrend.
The communication strategy has shifted away from yen jawboning to giving the bond market more of the clarity it needs.
Katayama said on Tuesday the government has no plan to set a ceiling for annual debt issuance, but would keep the amount "within a range investors would view as reasonable."
Takashi Fujiwara, chief fund manager at Resona Asset Management's fixed income investment division, said Katayama was positive for the JGB market as she could communicate with the market logically.
"The government’s communication on the JGBs is increasing, and that is because every time the government announces something new, there is a 'shock' in the market, and that subsequently weakens the yen,” Fujiwara said.
Takaichi and Katayama are now pitching the administration's expansionary fiscal policy as boosting Japan's growth potential, thereby helping enhance the appeal of the yen and JGBs.
For now, markets remain unconvinced with yields on track for further rises amid looming prospects of bigger debt issuance that would strain Japan's already worsening finances.
And the yen could see more volatility this week when the U.S. Federal Reserve and Bank of Japan hold policy meetings. While both are seen keeping rates steady, hawkish hints from the Fed could accelerate yen falls versus the dollar.
"The administration faces two big headwinds: slumping approval ratings, and declines in yen and JGBs caused by eroding market trust in its fiscal policy. I don't think Takaichi has succeeded in fixing either of them," said former BOJ board member Takahide Kiuchi.
"To recover market trust, the administration needs to show with specific facts and figures its focus on fiscal discipline."
(Reporting by Leika Kihara and Tamiyuki Kihara; additional reporting by Makiko Yamazaki and Junko Fujita; Editing by Sam Holmes)
