Our scenario for stronger yen, yield curve inversion and possible political realignment in Japan

Japan stocks performance likely to continue to disappoint in the near term
With dollar/yen rate continuing to head lower as BOJ has finally begun correcting its big policy mistakes of the past two years in keeping its monetary policy unnecessarily too accommodative, we continue to think the earnings picture of Japan’s exporters and multinationals which are the big constituents of the Nikkei will likely get murkier as much of the forex gains that have greatly flattered corporate earnings in the past two years disappear. Indeed, at the current forex levels which is finally leaving the yen’s value higher than at this time last year, almost all these firms will likely to cut their full term earnings projections.

Although we don’t think BOJ will hike rates again in the very near term given weakening overseas demand and the recent yen’s strength which has relieved some pressure on Japan’s central bank to act, we do see more room for yen’s appreciation as the pressure is now mounting on the US Federal Reserve to ease its monetary policy more aggressively to support the US economy which is showing notable signs of slowing. 

To be sure, there is still much debate whether the Fed needs to cut rates by 50bps, especially given the fact that commodity prices have remained on a notable downtrend which should ease concerns about inflationary outlook. Shipping freight rates are also easing suggesting that earlier supply disruptions are starting to ease while weaker demand is taking hold.

With BOJ likely to resume its path towards policy normalisation, more likely after the coming meeting as concerns about a big spike in JGB yields have receded and domestic institutions are starting to raise their asset allocation to Japan’s sovereign bonds, we think the angle of attack by the two central banks in modifying their monetary policy in opposite directions is less important than the ultimate direction of where the rates are heading. This leaves us fairly bullish on the outlook of the Japanese currency which we think should settle somewhere around 130 to the dollar by year-end. 

We continue to see risk of a yield curve inversion
Although our less sanguine views about Japanese stocks this year have been very unpopular among investors and has not done us any favours in expanding our reach among global equity investors looking at Japan, our scenario for a potential inversion of Japan’s yield curve by Q1 of next year which we first called for in July and one which has made us highly cautious of holding shares of Japan’s top lenders has made us even more of an outlier among market participants with most overseas investors looking heavily weighted in shares of Japan’s megabanks.

This outlook is partly due to our long held view that if BOJ just stopped its QE program which it has curtailed by half in the previous month, there would be plenty of natural demand by domestic institutional investors who would likely to be attracted to higher risk free domestic yields. We thus continue to think that there is a natural ceiling to Japan’s 10 year benchmark yield, somewhere around 1.5% or 60bps higher than current levels. In fact, we are already seeing some domestic financial institutions looking to notably raise their asset allocation to longer dated Japanese government bonds. 

At the same time much of BOJ’s quantitive tightening is reportedly targeting the shorter end of the curve while MOF is also looking to increase its issuance of shorter dated paper to keep their refinancing costs low. The combination of these factors leave us fairly confident that not only the yield curve will further flatten this year but given the the massive size of BOJ’s previous QE and its past heavy handed yield curve control which are now being dismantled, we should see 2-10s inverting at some stage by early 2025. 

Needless to add, the above would be another unwelcome development for Japan’s stock market bulls which have not only been banking on weak yen to keep earnings growth momentum intact but for the steeper yield curve to keep shares of bank stocks on their outperformance path. With domestic institutions now most likely to trim their domestic stock holdings in favour of bonds, supply demand in the stock market does not look very encouraging in the near term. 

LDP leadership race could be followed by a major political turmoil
Although the tight US presidential election race is gripping markets and looking hugely consequential to global economy and geopolitics as a whole, we think Japan’s political establishment is going through its own shape shifting process which could have a big impact on domestic policies for years to come.

With an unprecedented number of 9 lawmakers throwing their name in the hat for LDP’s leadership race to replace Kishida-san as prime minister this month we think who wins the race is probably less important than what may come after. With LDP factions more or less disbanded because of the flush fund scandal, we think we may be seeing the beginning of the end for Japan’s ruling party as we know it and one which is increasingly likely to fracture from here.

With LDP’s junior coalition partner, the Komeito party also going through its own leadership race after 15 years and having had big policy disagreements with the LDP since the late Abe-san stepped down as PM, there seem to be even more uncertainties ahead. These developments reminds us of a time when Ichiro Ozawa defected from LDP in 1993 and took more than 40 lawmakers with him, marking a significant turning point for the ruling party which was briefly toppled from governing Japan.

These political developments in Japan seem a lot more significant than just one shadow shogun defecting and could be the harbinger of a major political realignment that could create number of smaller parties that in the future will need to form a bigger coalition to rule the country. Although it is impossible to predict exactly when and how this realignment will take shape, it could destabilise the political establishment for a while although ultimately, we see this as a very positive development for Japan’s democracy.