Yen At 125 Less Black Swan Than Gray Under Ishiba

Those“aspects” include the Nikkei 225 Stock Average suffering its worst decline since October 1987 following the BOJ's move to raise rates to 0.25%. On Monday alone, the Nikkei fell 5% as traders assessed Ishiba's anticipated economic policy mix.

Yet it's hard to refute the logic underlying Ishiba's take here. The rationale is that 25 years of obsessive exchange-rate manipulation has backfired in ways few LDP heavyweights will admit. This goes for the two LDP-election frontrunners Ishiba outmaneuvered for his shock win.

One is lawmaker Sanae Takaichi, who fancies herself the natural heir to former Prime Minister Shinzo Abe's reflationary stimulus policies.

On September 19, Takaichi said,“I think it would be stupid to raise interest rates now.” She added that“what we're seeing now is cost-push inflation. We must keep monetary policy accommodative until real wages stably turn positive.”

The Ishiba take is that a quarter century of free money deadened the urgency for government after government to modernize labor markets, slash red tape, support a startup boom, empower women and slow the pivot of financial power away from Tokyo toward Shanghai.

It also reduced pressure on corporate CEOs to restructure, innovate and take big risks on new products, technologies and sectors. It helps explain why Japan ranks 30th among 38 Organization for Economic Cooperation and Development (OECD) members in productivity.

Beginning in 2013, the BOJ supersized quantitative easing. It hoarded so many government bonds and stocks that by 2018, the BOJ's balance sheet topped the size of Japan's US$4.7 trillion worth of annual output . That buying binge made it harder for the BOJ to find an exit, a daunting challenge that's fallen to Ueda.

The violent global market reaction to the BOJ's
July 31
tightening has left Team Ueda gun-shy about additional moves. Yet the conditions for tightening monetary policy may only intensify as inflation heats up.

The problem, says Takeshi Yamaguchi, economist at Morgan Stanley MUFG, is an“increasingly severe shortage at small non-manufacturers” that's driving“further worsening in the labor situation overall.”

Earlier this year, Japanese unions scored the biggest pay increase for workers in 33 years. It's part of Tokyo's efforts over the last dozen years to generate a“virtuous cycle” of wage increases. The plan is to boost corporate profits to levels that encourage even fatter paychecks, which in turn would increase consumption and gross domestic product (GDP).

Yet, such gains could be inflationary if not matched by steps to increase overall productivity. In August, Japan's“core” consumer price index rose at a 2.8% year-on-year rate, well above Tokyo's 2% target. It marked the fourth straight month of acceleration.

“Accordingly, underlying inflation should ... prompt another rate hike by the Bank of Japan at its October meeting,” says Marcel Thieliant, Asia-Pacific economist at Capital Economics.

Ishiba could give the move needed political cover. A big reason Ishiba objects to the weak yen is his belief it's damaging confidence at home and abroad. It reduces the purchasing power of households and leaves Japan vulnerable to imported inflation via higher commodity prices.

Many foreign investors, meanwhile, are confounded by a highly developed economy maintaining a developing-nation-like exchange-rate policy. If Japan Inc is not ready to thrive without history's biggest corporate welfare scheme, why should investors trust that the“Japan is back” narrative is for real this time?

Many economists figure the political empire will strike back and dissuade Ishiba from prodding the BOJ to drive the yen higher. If so, the policies of the outgoing Fumio Kishida government will live on.

Now that LDP bigwigs have talked to Ishiba, his“stance on monetary policy is thought to be the same as the Kishida administration, which generally respects the independence of the BOJ, and he is not actively in favor of raising interest rates,” says Masafumi Yamamoto, strategist at Mizuho Securities.“So, the scope for the yen to continue to appreciate in the lead-up to the formation of the new cabinet is likely to be limited.”

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Analysts at UBS concur, writing in a note that Ishiba's latest comments to the local media are that“monetary policy must remain accommodative...In this context, we think the latest political developments in Japan still justify a more gradual JPY appreciation path, rather than an accelerated one.”

Strategist Yukio Ishizuki at Daiwa Securities agrees that“Ishiba's comments over the weekend were trying to put out the fire of his hawkish image.”

Since then, says strategist
Jeff Weniger at
Wisdom Tree
Asset Management,“things have settled down. Investors have come to realize that there will still be a yawning gap between the two nations' cost of money even if the Fed Funds Rate gets the chainsaw.”

The US Federal Reserve outlook is indeed a wildcard.“The lack of clarity on how the easing cycle will unfold and the inverted yield curves,” are key challenges facing global markets , says
Teresa Ho, a strategist at
JPMorgan Chase & Co.

This might explain why many currency traders are sticking with the idea that the yen won't stray too far from current levels. According to data from the US Commodity Futures Trading Commission (CFTC), hedge funds and other speculative entities have more than 66,000 positions betting on a rising yen. That's the most since October 2016.

The size of this position owes in part to the so-called“yen-carry trade,” the result of the BOJ holding rates at or near zero since 1999, making Japan the world's top creditor nation.

Borrowing cheaply in yen and deploying those funds in higher-yielding assets around the globe became the most popular maneuver in finance. Bloomberg data puts the scale of the trade at about $4.4 trillion, a sum larger than India's economy and roughly twice the size of Russia's.

Should the yen-carry trade go awry, the global financial system would shiver and quake. But with Ishiba at the helm, a yen move toward 125 to the dollar would be less a black swan than a gray one.

Follow William Pesek on X at @WilliamPesek

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