Yen movements and long-term rates: The calm before the storm?

Our view is that the post-election yen appreciation was driven by an unwinding of short-yen positions amid heightened vigilance over possible FX intervention, as well as multiple factors weighing on the U.S. dollar.

Remarks by Prime Minister Takaichi and others are gradually reinforcing the view that fiscal policy will be pragmatic, potentially easing upward pressure on long-term interest rates by reducing doubts around Japan’s fiscal sustainability.

While it remains necessary to calmly and objectively assess the Takaichi administration’s fiscal management, we view the risks of a sharp yen sell-off and a spike in long-term interest rates as now very limited.

The dog that didn’t bark

For the House of Representatives election held on February 8, markets had largely expected that a victory for the ruling parties would lift equities, weaken the yen, and push long-term interest rates higher. In reality, however, while the Nikkei posted a sharp gain, USD/JPY moved in the opposite direction—toward dollar weakness and yen strength—and long-erm rates did not rise significantly. This sudden strengthening of the yen caught many market participants by surprise. Below, we examine why USD/JPY and long-term interest rates moved contrary to expectations and provide an outlook going forward.

Starting with USD/JPY, there was an initial if only brief reaction where  a stronger dollar and weaker yen were seen in the early hours of February 9 (Japan time). SMDAM’s house view is that this first bout of post-election yen depreciation was limited due to very strong market vigilance over possible FX interventions by the Japanese authorities. In this regard, market speculation that emerged in late January about “rate checks” by the Japanese and U.S. authorities appears to have been a factor, contributing to a reduction in speculative short-yen positions. Additionally, as shown in the table below, the existence of multiple factors weighing on the U.S. dollar likely also played a role in a relative sense.

Takaichi’s balance between responsibility and radicalism

Turning to long-term interest rates, while the 10-year JGB yield rose on the 9th, it fell on the 10th, remaining relatively calm overall and maintaining the heightened level it has reached over recent months. The market had been focused on what Prime Minister Takaichi would say about fiscal management after the Lower House election. At a much anticipated press conference on February 9 she stated that the consumption tax on food would be set to zero for a limited period of two years, that the funding would not rely on special deficit-financing bonds, and that she would like to compile an interim summary at the National Council before early summer. 

As can be summed up in the table below, we see the policy measures as part of a broader picture which suggests upwards pressure on long-term rates.

In addition, on the 8th, Finance Minister Katayama disclosed on national TV that the government intends to thoroughly review broad government spending to identify where savings on fiscal resources can be made, regarding a cut in the consumption tax on food. In response to these remarks, the view has gradually spread that the Takaichi administration will pursue highly pragmatic fiscal management, and as concerns about fiscal deterioration and accelerating inflation have eased to some extent, we suspect upward pressure on long-term interest rates has declined—also contributing to a check on yen depreciation.

Has the worst volatility already passed?

However, we believe it will still take time for the Takaichi administration’s fiscal policy to win the market’s confidence, and we continue to see an environment in which yen depreciation and rising long-term interest rates could occur relatively easily. That said, even if USD/JPY moves back above 157 and the dollar strengthens against the yen, a rapid move beyond 160 seems unlikely given strong market vigilance over potential FX intervention. In addition, when assessing the outlook for USD/JPY, monetary policy by the BOJ and the U.S. Federal Reserve will also be in focus. 

For the 10-year JGB yield, the key question is whether it will break above the recent 2.35% level. Exactly how the Takaichi administration’s patented ‘responsible proactive fiscal policy’ will be implemented remains to be seen, and attention will be on discussions at the National Council as well as progress in fiscal efficiency measures led by the Japanese version of DOGE (a government efficiency department bearing some limited resemblance to the US department briefly led by Elon Musk). 

Our view is that while the broad direction of the Takaichi administration’s fiscal policy may be expansionary, it is highly likely that her and her team will show some regard for fiscal discipline given the need to keep the bond market calm. This means Takaichi is unlikely to be fully unrestrained in her approach, and accordingly, we see limited risk of a sharp spike in long-term interest rates.