ROI-Takaichi's smooth victory may yet signal rocky ride for Japan's yen, bonds: McGeever

By Jamie McGeever

ORLANDO, Florida, Feb 9 (Reuters) - Financial markets supposedly hate "uncertainty", yet the total clarity of Japanese Prime Minister Sanae Takaichi’s election victory on Sunday could usher in a period of heightened volatility in the country's currency and bond markets.

The ruling Liberal Democratic Party won in a landslide in lower house elections, securing a supermajority with two-thirds of seats. That means Takaichi – who has promised lavish fiscal stimulus – can now override the upper chamber, which she does not control.

Takaichi's planned largesse – including a pledge to suspend the 8% sales tax on food for two years – has been roiling Japanese government bonds (JGBs) and the yen for weeks, sending both to historically weak levels.

That meant much of the incoming spending splurge was already "priced in" before the poll. Long-dated JGB yields quickly retreated after initially popping higher on Monday, and the yen rallied towards 156 per dollar after initially slipping to 158 per dollar.

That's likely because Japan's top currency diplomat Atsushi Mimura said the Ministry of Finance (MoF) is closely monitoring the exchange rate. MoF officials have repeatedly warned that all options are on the table to counter what it calls excessive yen volatility.

Currency traders inferred that to mean direct intervention to prop up the yen remains likely if the currency continues to depreciate towards the 160 per dollar mark.

But this calm may not last. There is still little clarity on how Takaichi will fund her fiscal push. The food sales tax suspension alone is expected to cost roughly 5 trillion yen ($32 billion).

On top of this, Takaichi's mandate raises the potential for friction between the government and the Bank of Japan.

If the prime minister's fiscal loosening triggers a renewed JGB selloff and spike in yields, the BOJ will be under greater pressure to counter with more aggressive monetary tightening, ramping up the pace and magnitude of interest rate hikes.

While BOJ Governor Kazuo Ueda and his colleagues may be prepared to do that, sharply higher borrowing costs weren't part of Takaichi's offer to the Japanese electorate. Would her administration lean on the BOJ not to act too aggressively? Quite possibly.

DOLLAR/YEN EYES 160.00

This speaks to the global debate over central bank independence that has caught fire in the last year, as U.S. President Donald Trump's administration has widened the scope of attacks on the Federal Reserve. The BOJ has monetary independence but is widely seen as having one of the closest working relationships with its government among developed market peers.

If the government were to increase pressure on the BOJ not to accelerate its tightening cycle, it risks accelerating the yen's decline, thereby increasing the volatility that the MoF has warned against.

"We expect implied volatility to pick up again, with USD/JPY moving towards and through 160 as markets digest the full impact of the election results," Goldman Sachs analysts wrote on Sunday.

Their counterparts at Barclays caution that tolerance among the public and officials for high inflation, fueled by a weak yen, will be low.

Washington's tolerance for further yen depreciation against the U.S. dollar will also be limited, as the Trump administration has made it clear that it seeks to have a more competitive currency.

This all suggests that some form of official action - be it rate hikes or FX intervention - might be inevitable. Either will make for choppier markets.

'MAKE JAPAN GREAT AGAIN'

There is another way to look at the election results, however. The market's positive response so far suggests there is a chance that Takaichi's platform – with its "Make Japan Great Again" ethos – could end up lifting the yen and Japanese assets given the promise of higher growth.

That's especially true if it tempts back some of the $3.4 trillion in net foreign assets Japanese investors held overseas.

Then there are simple deficit fundamentals, which would suggest that selling yen for dollars might not be a good bet. While Japan has a massive debt-to-GDP ratio of over 200%, it also has a current account surplus and a budget deficit of only around 3% of GDP, roughly half that of the U.S., which has long run twin deficits.

But Tokyo's fiscal direction of travel seems pretty clear, and, unlike the dollar, the yen doesn't have the cushion offered by being the world’s main reserve asset.

Japan's currency and bonds, therefore, could remain on the defensive, suggesting that political certainty isn't always calming.

(The opinions expressed here are those of the author, a columnist for Reuters)

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