Japan PM Takaichi's First Market Test: Stimulus Fears Undermine Gains

Key Takeaways

• Fears over Japan's upcoming government stimulus plan may end post-election gains seen after PM Takaichi's election.
• Japanese bonds have sold off and the yen has weakened amid concerns about Japan's fiscal health.
• Japanese stocks have fallen this week, erasing post-election gains.
• Analysts foresee more pressure on Japanese assets if Takaichi loses policy credibility.
• A larger-than-expected stimulus plan could trigger intervention by the Bank of Japan in the currency market.

Japanese Prime Minister Sanae Takaichi is facing her first major market test since being elected, as mounting anxieties surrounding the upcoming government stimulus package threaten to undo the market gains seen after she took office. Fears that her spending plans could jeopardize Japan's fiscal health have led to a sell-off in the bond market and a weakening yen, pushing it closer to levels that could trigger government intervention.

The Nikkei 225 index has seen a notable decline this week, its largest since April. With the government expected to unveil its much-anticipated economic plan on Friday, the prospect of investors dumping Japanese assets looms large. Bond yields are at multi-decade highs, and the yen dipped 1% overnight, adding to the pressure on the economy.

Mark Dowding, chief investment officer at RBC BlueBay Asset Management, cautions that if Takaichi loses policy credibility, investors could start selling all Japanese assets. He added that if the perception grows that Japan is heading towards policy errors, they might increase their short positions on the short end of the yield curve.

The recent sell-offs across asset classes highlight the fragility of the so-called "Takaichi trade," which propelled Japanese stocks to record highs in October, fueled by bets that fiscal expansion would reinvigorate growth. However, by November 19, less than a month into Takaichi's term, the Nikkei 225 had erased all its post-election gains, delivering a jolt of reality to investors.

The yen has also fallen to its lowest point against the U.S. dollar since January, primarily driven by the dollar's strength amid diminished expectations of interest rate cuts by the Federal Reserve. The yen is currently trading around 157 per dollar, and if it falls below 158.87, it would mark its lowest level since last July.

Amir Anvarzadeh, a Japan equity strategist at Asymmetric Advisors Pte, bluntly states, "The honeymoon is over." He points out that while traders initially cheered Takaichi and her pro-stimulus policies, many are now feeling "suffocated."

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Anvarzadeh believes that it is not just concerns about fiscal spending that are hurting market sentiment. In the past two weeks, Takaichi has abandoned the government's annual budget balancing target, vowed to make Japan's corporate governance code less focused on shareholder interests, and sparked diplomatic friction. He says these moves have unsettled investors, pressuring the stock market and causing yields to spike.

The unveiling of the stimulus plan will be the next crucial test. Takaichi's stimulus is expected to exceed the 13.9 trillion yen launched by her predecessor, with some lawmakers even pushing for an extra budget of around 25 trillion yen.

Japan Hits Market Milestone Amid Fiscal Fears

Hiroshi Namioka, chief strategist and fund manager at T&D Asset Management Co, says, "The 25 trillion yen size is too large, and people are questioning whether it is really necessary." He fears the risk of a "triple kill" after the plan's release – a simultaneous decline in stocks, bonds, and the yen, similar to the market turmoil suffered by Britain in 2022 during Liz Truss's tenure.

Alex Loo, a macro strategist at TD Securities based in Singapore, notes that if Takaichi pursues a "massive budget," Japanese long-term bond yields could climb further, and the yen could weaken towards 160.

Loo adds that any further declines could prompt intervention by Japanese authorities. One indicator tracking the speed of the currency's decline – a key trigger point for action – has repeatedly approached levels consistent with previous interventions in the past month.

A weak yen is typically beneficial for the Japanese stock market, especially exporters, but Japan's sparked diplomatic friction, coupled with a pullback in global technology stocks and cryptocurrencies, have offered little respite for Japan's benchmark stock index.

The Nikkei rose more than 4% on Thursday as better-than-expected revenue forecasts from Nvidia boosted sentiment among global stock investors. But so far this month, Japan's blue-chip stock index is still underperforming the S&P 500 and the MSCI global benchmark.

Vishnu Varathan, head of economics and strategy at Mizuho Bank, says, "You're seeing a very anomalous combination, where the Nikkei is underperforming despite a weaker yen; the yen is weak despite higher yields."

While short-term volatility may persist, some investors still believe that Takaichi's spending plans will support Japanese assets over time. Thomas Mathews, head of Asia Pacific markets at Capital Economics, says that the injection of government funds could heat up the economy, thereby strengthening the case for interest rate hikes and boosting the yen.

"If she does fiscal stimulus and the economy starts overheating, it will be hard to avoid rate hikes," Mathews says. He adds that this could trigger a "significant rally in the yen" next year.