Japanese Election Update

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Japan’s election is three weeks away.  Since last June’s UK referendum, through the US election, and more recently, the German election, there have been plenty of political surprises.  Like Merkel, Abe may find that winning is not enough.  Merkel was denied a majority and may have to form a coalition that no doubt will be more unwieldy than the coalition with the SPD.  

There is little doubt that the LDP will remain the largest party in Japan.  The new national opposition party (Party of Hope) is not fielding enough candidates to secure a majority in the new 465-seat Diet.  Moreover, according to a Kyodo survey, the LDP is drawing support from about 24% of the voters, while the Party of Hope is pulling about 15%.  The survey found 43% were undecided.

Abe can still lose by winning.  This sounds like an oxymoron, but there is truth in the assessment.  The LDP has a simple majority (294 seats) and a supermajority (329 seats) with the support of the Komeito Party.   If the LDP loses its simple majority or 61 seats, Abe’s political future may be at risk.  His term as LDP head ends in a year and he would likely face a challenger.

Two LDP candidates come to mind.  The first is Shigeru Ishiba, who heads a faction of 19 members in the lower chamber.  The challenge is a faction needs 20 members to nominate a party head.  The second is the new LDP policy chief and former Foreign Minister, Fumio Kishida, who was given the new assignment as an apparent concession after the stunning LDP defeat in the Tokyo elections in July.

Abe is supporting several unpopular measures, and the Governor of Tokyo and head of the Party of hope, Koike is pushing for the advantage.  Specifically, Abe supports re-opening nuclear power plants and is committed to raising the sales tax from the current 8% to 10% in 2019. As part of his campaign, Abe has offered not to use the proceeds of the sales tax increase to pay down the debt, as was the initial intention, but to pay for pre-school and higher education.  Koike is campaigning to phase out nuclear power and to freeze the sales tax.

The previous main opposition party, the DPJ has largely folded into the Party of Hope.  Some of its members may run as independent candidates.  A left-of-center faction has formed a new party.  Koike may seek cooperation from other small opposition parties.  For example, the regional conservative Nippon Ishin no Kai has agreed not to run candidates against the Party of Hope in Osaka.

Abe also wants to change the Constitution to strengthen Japan’s military presence.  More than half of the people Kyodo surveyed are opposed to the constitutional changes Abe has endorsed.   About a third to those surveyed agreed with Abe.   The Kyodo survey found that Abe’s approval rating fell below his disapproval rating.

Abe is a known quantity for investors.  He offers fiscal and monetary stimulus.  He favors a soft yen.  This is the traditional LDP policy mix.  The policy of the Party of Hope is not known.   Meanwhile, the Japanese economy is doing nearly as well as Abe could have wished.  The Tankan Survey released earlier today show sentiment among large manufacturers is at its best level since 2007.  It is enjoying its longest expansion in several years.

Assuming the LDP remains the largest party in Japan, but Abe is weakened, there would still be increased uncertainty about the trajectory of monetary policy.  BOJ Kuroda’s term expires in early April next year.  Typically, the BOJ Governor serves one five-year term.  While a weakened Abe may not be strong enough to resist tradition, it is likely that Kuroda’s replacement shares his basic philosophy as opposed to return to the Shirakawa era.

We see two main drivers of the dollar-yen rate.  First and most important is the direction of the US 10-year yield.  The correlation between the (percent) change in the US yield and the (percent) change in the dollar-yen exchange rate over the past 60 days appears to be the highest (0.82) since at least 2000.  Second, we pressure on the yen coming from the large dollar premium for yen on a three-month cross currency swap basis.  The dollar premium stands at 49 bp more than LIBOR today, which is the most in seven months.  Recall that at the end of last year, as the dollar traded above JPY118, the dollar premium on the three-month cross currency swap was near 90 bp on top of LIBOR.

In the options market, implied vol is jumped around the election (three-week vol is ~9.95%, while the two-week vol is ~8.33%).  With US 10-year yields at the upper end of their six-month range, it should not surprise the dollar is firm against the yen.  A preliminary shelf was carved in the second part of last week near JPY112.20.  Last weeks high was near JPY113.25.  The dollar has run up for near JPY107.30 on September 8, and the technical indicators are stretched.  The Slow Stochastic has already turned lower.  However, the key takeaway here is that the technical indicators of the weekly bar charts suggest a constructive medium-term outlook.