Japan's new leader weakens the yen

The yen sold off after Japan elected new political leadership, sending USD/JPY back towards 150, a level traders watch closely. The market reached its view quickly. The new government's promises of fiscal expansion and its open preference for easy money have upset the Bank of Japan's plans to bring rates back to normal.

The trigger was the victory of Sanae Takaichi in the Liberal Democratic Party's leadership contest on 4 October, which puts her in line to become prime minister when parliament votes. Ms Takaichi, a protégé of the late Shinzo Abe, has long backed the mix of aggressive monetary easing and fiscal stimulus that bore his name. Markets had expected a win for the more orthodox Shinjiro Koizumi. On the first day of trading after the result, the Nikkei stock index jumped to a record and yields on long-dated government bonds rose, while the yen fell.

Ueda boxed in

Tokyo's new leaders took office promising large supplementary budgets and energy subsidies, and no more monetary tightening until real wage growth can sustain itself. That leaves Bank of Japan governor Ueda in a very awkward spot. Raising rates against the explicit wishes of the ruling coalition could provoke an institutional fight and choke off fragile consumer demand.

The central bank had been edging towards a move. Its policy rate has stood at 0.5 per cent since January, and at its September meeting two of the nine board members voted for an increase. The bank also announced that it would begin selling the exchange-traded funds it bought during years of quantitative easing, a sign that it wants to keep unwinding the emergency measures of the past decade. Many in the market had pencilled in a rise at the October meeting at the end of the month. That now looks less likely.

How the yen gets weaker

The mechanism runs through the interest-rate gap. Even after the Federal Reserve's cut in September, short-term dollar rates are several percentage points above Japanese ones. An investor who borrows yen at close to zero and holds dollar assets earns that difference every day, provided the yen does not strengthen enough to wipe it out. Each signal that Japanese rates will stay low extends the expected life of that trade and encourages more of it, which means more selling of yen.

Fiscal expansion adds a second channel. Larger budgets financed by more government bonds push up long-term Japanese yields, but if the central bank is seen as unwilling to lean against inflation, investors demand compensation through a weaker currency rather than simply higher yields. That is the pattern bond markets now associate with fiscal dominance, where monetary policy is constrained by the government's borrowing needs.

Carry traders return

With Japanese rates held down and US Treasury yields still high, the gap in interest rates between the two remains very wide. Macro hedge funds that unwound yen carry trades in late 2024 have been rebuilding short yen positions to collect the carry.

They have reason to remember the risk. In early August 2024, days after the Bank of Japan raised rates and American jobs data disappointed, a rapid unwinding of carry positions sent the yen sharply higher and the Nikkei down more than 12 per cent in a single session, its worst day since 1987. A carry trade rebuilt on the assumption that Tokyo will not tighten is exposed to exactly that kind of reversal if the assumption proves wrong.

The line at 160

The Ministry of Finance is the other player. When the yen weakened past 160 per dollar in 2024, the ministry intervened on several occasions, selling dollars from Japan's reserves to support the currency. The finance ministry and the central bank are formally separate, but a government that wants low rates and a stable yen at the same time has to rely more heavily on intervention, which buys time without changing the rate gap that drives the currency.

Japanese households and importers are the losers from a weaker yen. Food and energy are largely imported, and a falling currency raises their cost, which is precisely the inflation that erodes the real wage growth the new government says it wants to protect. Exporters and the big manufacturers that dominate the Nikkei are the winners, since their foreign earnings are worth more in yen.

The case for a firmer yen

The strongest argument against further weakness is that the new leadership may prove more pragmatic in office than in the campaign. Ms Takaichi has not yet formed a government, and the LDP does not command a majority in either house of parliament, so any budget will need support from other parties. The Bank of Japan also remains legally independent, and it could still raise rates later in the year if inflation stays above target. Any of those could cap the dollar's rise.

The signals to watch are the composition of the new cabinet and the choice of finance minister, the size of the first supplementary budget, the Bank of Japan's decision at the end of October and any warnings from the Ministry of Finance about excessive currency moves. Tokyo's embrace of loose fiscal policy all but caps the Bank of Japan's rate rises, and the yen will probably keep weakening as the price of paying for the government's stimulus. The likely path is a drift towards the levels that prompted intervention last year, with the central bank holding off until at least December and the finance ministry, not the Bank of Japan, left to defend the currency.