Japan: BOJ Shifts and Abe Pressure

Published on April 20, 2018

Japan’s Prime Minister Shinzo Abe has been ensnared in at least four scandals over the last few months that have led to a precipitous plunge in his personal poll ratings.

While clearly embattled, we expect Abe to survive these scandals, and to win a third term as President of the Liberal Democratic Party and Prime Minister of Japan. That may even come through a bold but risky gambit of calling snap elections.

Either way, Abe’s political continuity does not necessarily mean the absence of changes to BOJ monetary policy this year.

*** BOJ Governor Haruhiko Kuroda, we believe, has been slowly laying the groundwork for a shift in the current Yield Curve Control bond purchase program targets to allow for some curve steepening in order to alleviate the continued pressure on the profitability and transmission capability of Japan’s banking system, especially the smaller banks. ***

*** That, we expect, will be achieved through a shift in the long end BOJ interest rate peg from the 10-year JGB to a shorter maturity, probably the 5-year JGB, letting longer yields drift up naturally. If conditions permit, those changes could come as soon as in the second half of this year. ***

*** Two main hurdles remain before that change is possible. One is to persuade Abe, with an eye on the potential contractionary effects of a further consumption tax hike likely to come in October of 2019, that the timing is right. The second is a weakening of the Japanese Yen to “safer” levels than it is in now, around 107. We believe both are possible, and the latter could entail only a modest move a bit above the 110 Usd/Yen rate. ***

Inflation, of course, also needs to cooperate for Kuroda to feel comfortable in effecting that change. But with the 2% target still elusive, even modest upticks in inflation, which are expected, could be enough to trigger the yield curve shift – once the other two hurdles are met.

But first, Abe will need to survive the mounting list of scandals.

Abe Under Pressure

Abe has been ensnared in at least four scandals over the last few months that have led to street protests and a precipitous plunge in his personal poll ratings, even against the backdrop of a strong economy and the relative success of his vaunted “Abenomics.”

The culmination of those hits to the Prime Minister and the speed and durability of the drop in his poll ratings have now raised alarm bells in financial markets over Abe’s chances for political survival in the upcoming internal election for leadership of the LDP (Liberal Democratic Party) slated for September this year. The ruling party was assumed, until recently, likely to effectively rubber stamp a third term for the embattled Prime Minister.

We believe Abe will likely win a third term as President of the LDP, and as Prime Minster of Japan, and survive these scandals. 

Despite his plunge in the polls, there is not, from what we understand, much appetite as things stand within the party to push for an alternative to Abe. The presumed leading challenger, Shigeru Ishiba, is known mainly for his tenure as Defense Minister and considered highly capable. But he is not seen by the party as a charismatic alternative to the still powerful Abe.

The other serious potential challenger, Shinjiro Koizumi, is the son of the popular former PM Junichiro Koizumi and very well liked. But at 37, Koizumi the Son is still considered by the ruling LDP to be far too young to take the helm of the party and country.

A Risky but Bold Potential Gambit

Indeed, we believe there is a fairly strong chance Abe might proactively dissolve the Lower house of the Diet and call for early general elections before then, perhaps in June or July.

While a bold, if not risky, gambit, even with the current low approval ratings, the LDP-Komei coalition would be highly likely to win a direct face-off against the hapless opposition parties – what is left of them. Public support for the Abe cabinet and the Prime Minster himself has been in decline, but it has been of little benefit to any (non-LDP) challengers.

A general election victory, even under smaller margins, would solidify the government, and calm a potentially more turbulent political environment.

Politics and Kuroda’s BOJ Strategy

Although we expect Abe to prevail, even in what we believe to be the unlikely case of an LDP coup and an Ishiba government, the political environment under which the Bank of Japan and Governor Kuroda operate should be little changed from now.

Ishiba is seen as a proponent of another hike in Japan’s consumption tax – as scheduled – in order to address Japan’s massive budget deficit, but he would be very likely in turn to continue to seek easy monetary policy support from the Bank of Japan as well to cushion the impact of a tax hike. So does Abe: a leadership battle will not be the driving force to BOJ changes.

Small Hurdles to BOJ Shift

If the yen can depreciate a bit more from here and the economy pick up a bit, the economic – and political – imperative for maintaining Kuroda’s now clearly distortionary, ultra-low interest rate policy exactly in place will disappear. 

To save Japanese banks, especially local banks, and to foster bank lending we believe Kuroda will then shift the longer end target of zero interest rate policy from the 10-year JGB to, say, 5-year JGBs, and let the long end drift up a bit naturally.

The two hurdles to that shift which remain are not huge, and could be met in the second half of this year.

The first hurdle is the Abe Cabinet. Abe still plans to hike the consumption tax from 8% to 10%, as currently planned and already twice postponed, in October of next year. The suspicion is that Abe would like the current ultra-easy policy to remain intact for some time longer to run the economy hot and avoid triggering an economic shock. Kuroda shares that view, and is believed to be a proponent of another consumption tax hike himself for fiscal reasons.

Almost all the recent economic data in Japan has been strong,however, almost shockingly so by recent standards, with a notable lag in inflation reaching Kuroda’s self-imposed 2% target. Even on that front, the inflation numbers are expected to improve, creating a window for Kuroda to persuade Abe to let the 10-year JGB at least drift a bit higher. Indeed, that process can better be managed before the data turns even stronger. 

The second hurdle is the yen rate. The Tankan Survey just released by the BOJ on April 2 showed the Usd/Yen rate for FY 2018 expected by large scale manufacturers to be 109.66. That is lower than where the yen stands now – plus or minus 107 – but not really by much.

Further appreciation of the yen would of course have a negative impact on exports, and on corporate sentiment. And a slight steepening of the yield curve would invariably lead to some tightness in the yen.

So a cushion would be prudent before allowing for a drift up in the 10-year yield. We expect that, given all else, to translate to somewhere a bit above – but not very far from – 110 Usd/Yen.

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