ANALYSIS-As Japan's Takaichi creates election history, only markets stand in her way

By Rocky Swift and Tom Westbrook

TOKYO, Feb 9 (Reuters) - The biggest landslide win in postwar history has given Japan's Prime Minister Sanae Takaichi a huge mandate to revitalise the economy, but investors say she has little room to run up deficits or pressure will be quickly back on bonds and the yen.

Takaichi's Liberal Democratic Party won more than two-thirds of seats in parliament's lower house on Sunday, giving her free rein to pass her agenda without negotiating with other parties or having to seek upper house approval.

The prime minister, who drew praise from conservative ally U.S. President Donald Trump on her victory, has tapped into voter disenchantment over the high cost of living but has also rattled markets with her expansionary fiscal agenda.

On Monday, though, Tokyo stocks surged to record highs in anticipation of stimulus flowing to consumers and Japan Inc.

Bonds and the yen - sliding for months as investor concerns focused on spending plans - were steady and awaiting details of where Takaichi proposes to take the budget of a country already carrying the heaviest debt burden in the developed world.

Where they move next matters for Japan, particularly as a weak currency has lifted living costs and inflation, and for the world since rising Japanese yields tend to drag down global bonds.

"It's no longer about getting Japan back on its feet. It is arguably on its feet. This is (about) making it sustainable," said Fred Neumann, chief Asia economist at HSBC in Hong Kong, of Takaichi's policy challenge.

"The market therefore will look very, very closely at any hints of fiscal slippage, any hints of kind of being more open to FX weakness, any hints that monetary policy might not react enough to any signs of inflation," he said.

"The markets will set an important constraint here."

On Monday the Nikkei .N225 and broader Topix .TOPX had scaled all-time peaks, notching gains of 3.9% and 2.3% respectively. .T

The yen JPY=, down 6% since Takaichi took charge of the LDP in October, was firmer at 156.35 to the dollar, while benchmark 10-year government bond yields JP10YTN=JBTC rose 5.5 basis points to where they sat two weeks ago at 2.28%.

"Market participants are focused less on the election result itself than on the substance, scale, funding, and consistency of the economic and fiscal policies," said Shoki Omori, chief desk strategist at Mizuho Securities in Tokyo.

NARROW PATH TO A STRONGER YEN

Part of the reason investors have not immediately taken so-called "Takaichi trades" further in the currency and debt markets is that some analysts expect the prime minister to use her strong mandate to become more responsive to markets as well as due to pressure from the U.S. to bolster the yen.

Bets on near-term rate hikes even went up a little, reflecting political stability clearing the way for the Bank of Japan to move - a contrast to when Takaichi first took office with a reputation for pressuring the central bank to slow rate hikes.

"In monetary policy, the Takaichi administration may, claiming public support based on the election results, temporarily increase pressure on the BOJ to maintain the status quo," said Naohiko Baba, chief Japan economist at Barclays in Tokyo.

"However, signalling such a stance could easily trigger further JPY depreciation," he said.

"Ultimately, public frustration with JPY‑driven cost‑push inflation, combined with pressure from the Trump administration, is expected to push the government back toward a stance of reluctantly allowing rate hikes to counter JPY weakness."

The U.S. has asked Japan to quell tumult in the bond market and the apparent participation of the New York Federal Reserve in checking dollar/yen rates last month suggested the Trump administration would be a supporter of a stronger yen.

To be sure, it won't take much for investors to return to selling yen or bonds. Momentum is a powerful force, and the direction of travel for bonds and the yen has been lower for years.

"Both JGB yields and the yen have been consolidating over the past couple of weeks into the election, so the outcome should now allow markets to re-engage existing trends," said Rong Ren Goh, portfolio manager at Eastspring Investments.

That means higher yields for long-dated bonds and a drift lower for the yen, he said.

An early test will be how Takaichi handles a pledge to suspend Japan's 8% sales tax on food, how she will pay for it, and how she will explain it to markets that have been only too eager to challenge her agenda.

Cutting the consumption tax will leave Tokyo with an estimated 5 trillion yen ($32 billion) annual revenue shortfall, causing a funding headache for Takaichi - and keeping markets nervous about the risk of fiscal slippage.

"Her plans for the cut in the consumption tax leave open big question marks about funding and how she's going to go about making the arithmetic add up," said Chris Scicluna, head of research at Daiwa Capital Markets Europe in London.

"And so I think uncertainty about fiscal policy is going to persist for some time to come."