The Yen (USDJPY) has been weakening this week, with the USDJPY once again trending towards levels that have sparked intervention in the past. A stronger dollar has contributed to the trend, but analysts generally attribute the move to the snap election scheduled for Sunday. Polls suggest that Prime Minister Sanae Takichi’s party will win a landslide victory, providing strong support for her fiscal program, which is seen as weakening the yen.

But that doesn’t mean that the USDJPY will suddenly spike. If the election results are as expected, then the market has likely already priced in the news. However, it would mean that the yen could be under increased pressure going forward. And given Japan’s status in the bond market, it could pressure many other major currencies as the yield floor rises.
 

Another Budget Crisis?

The Yen (USDJPY) is weakening because Takaichi is proposing an aggressive spending program coupled with tax cuts. Japan already has high levels of debt, which suggests the government would have to borrow even more. As a result, long-term JGB yields have been rising as investors sell their holdings of Japanese bonds, worried that interest rates will rise further.

Japan has a solid reputation for paying off its debt, so this isn’t a concern for traders worried about a default. The issue is that there are only a few ways a government can manage a debt of Japan’s size, and they all mean that long-term investors will lose money. If the government increases deficit spending, it expands the monetary base, which raises inflation. This erodes the value of long-term bonds because inflation erodes their value over time. If investors fear the government will have to increase borrowing to pay its debt, they will demand a higher premium to hold that debt, which is reflected in higher yields.
 

It’s a Global Problem

Japan has the highest debt-to-GDP ratio in the world, so it is in a particularly tight spot in this regard. But it remains a significant problem for many other countries, notably the EU and the US. The US spends more on interest payments on its debt than on defense. European countries are struggling to meet Eurozone rules about deficit spending and debt ratios, which are depressing the shared economy.

For decades, Japan had very low bond yields because the BOJ was buying up the government’s debt. This flooded the currency into the economy, which would otherwise have caused inflation, but the low rates made Japan a very attractive destination for carry trading. Because Japan kept interest rates relatively low, this pulled down rates in other major economies through arbitrage. So, if yields in Japan were to rise substantially as a result of Takaichi’s policies, it would be a global problem.
 

No Rescue From the BOJ?

The situation is causing a particular headache for the BOJ, which has been grappling with high inflation due to the weak currency. Japan imports the majority of its consumer goods, so a weak currency translates into higher consumer costs. However, the BOJ can’t raise rates too fast, or this could trigger a financial crisis as banks and insurance companies lose money.

Takaichi’s spending proposals would likely increase inflation, putting pressure on the BOJ to raise rates. But, given that inflation is already above target, the bank could be raising rates as fast as it can. If investors sense this vulnerability, they could sell yen, which would drastically weaken the currency. What could forestall this is if Takaichi doesn’t get as strong a mandate as expected, with a tighter election result constraining her aggressive fiscal policy. That might cause the Yen (USDJPY) to gain some strength.

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