USD/JPY: BofA outlines market scenarios tied to election in Japan 

Investing.com - Japan holds an upper house vote on Sunday, an outcome that could jolt investor confidence in the world’s fourth largest economy, potentially impacting the yen.

Prime Minister Shigeru Ishiba’s Liberal Democratic Party (LDP), which has ruled for most of the post-war period, and its partner Komeito, are forecast to lose their majority in a repeat of last year’s election for the more-powerful lower house.

Market consensus has leaned toward the LDP losing its coalition majority in recent days, but positioning may be lagging the expectation for this base case, according analysts at Bank of America Securities, in a note dated July 18.

Implied volatility has recently risen, but one-week volatility at 12 does not look particularly high, BofA said, while CFTC data also shows that CTAs still had substantial long yen positions as of July 11. 

Post-election price movements will likely differ depending on whether the LDP prevails or loses its coalition majority; whether Ishiba stays on as prime minister; and the outcome of the LDP leadership election if Ishiba steps down.  

If the LDP loses its coalition majority, we would expect the yen to weaken on Monday.

FX liquidity will likely be sparse given that Monday is a public holiday in Japan, and the JGB and stock markets will also be closed; this could drive FX market speculation that inflates price volatility, BofA said.

“We think the market would fully price in political uncertainty if the LDP-Komeito coalition follows last year’s Lower House loss by failing to retain its Upper House majority,” BofA said. “Rapid gains by opposition parties that advocate tax cuts would raise concerns about a larger autumn supplementary budget and longer-term fiscal risk.”

While the market is coming to see this as the baseline scenario, investor positioning does not fully reflect it. 

“In terms of level, we would expect USD/JPY to rise to 150-151.”

The scenario of Ishiba resigning as PM would cause the market to factor in the risk of a subsequent LDP leadership election, driving further yen weakness and higher volatility.

“This could occur amid concerns about the risk of a fiscally loose administration as the market focus shifts to fiscal expansion,” said BofA. “We think selling pressure for JGBs and Japanese stocks could increase when markets reopen on Tuesday after the holiday.”

“However, the winner of a prospective LDP leadership election would still be unclear at that point. Unless Sanae Takaichi or other fiscal doves emerge as the clear favorite, taking profit after the yen weakens somewhat versus USD (to 152-153) would be prudent,“ BofA said.

For instance, a Shinjiro Koizumi administration could cause the market’s mood to shift from fiscal expansion concerns to expectations for structural reforms, causing investors to switch from “sell Japan” to “buy Japan”. 

If Ishiba declares his intention to remain in office and seek to expand the coalition by inviting a party compatible with his political stance, this could ease concerns about procyclical fiscal policy and cause USD/JPY to initially pull back to around 148s.

However, we think the pullback would be short-lived, with USD/JPY rising above 150 again after the Obon holidays.

This scenario could lead to prolonged dissatisfaction within the LDP, and a move by its conservative faction and advocates of aggressive fiscal policy to replace Ishiba could occur at any time. 

The administration’s approval ratings are likely to remain weak absent catalysts for a bounce, possibly prolonging political uncertainty and leaving the Ishiba administration as lame duck.

“Downward pressure on the yen could ease until the Obon holidays, but we see a high risk that the yen could weaken again and the JGB yield curve could steepen through the autumn. We would therefore remain short JPY,” the U.S. bank added.

If the LDP maintains its Upper House majority, we would expect the yen to rebound to around 146s, its level before the market began pricing in an LDP loss of its coalition majority. 

“We think an LDP victory would reassure the market that fiscal risk has been averted, prompting a rally for superlong JGBs and a moderate recovery in the market’s expectations for BoJ rate hikes,” BofA said.

However, we think the yen’s bounce would be short-lived barring a convincing win for the LDP--for example, the LDP-Komeito coalition securing a majority of the seats up for reelection. 

If the Ishiba administration keeps its majority but loses seats, its ability to unify the party may not recover appreciably.

At 09:00 ET (13:00 GMT), USD/JPY traded 0.1% lower at ¥148.42.