Yen volatility amid Japan's leadership uncertainty

Japan’s political scene has been on a rollercoaster in recent weeks, injecting volatility into financial markets. The 26-year Liberal Democratic Party (LDP)-Komeito alliance collapsed after Sanae Takaichi was elected as the new LDP president on Oct. 4. The unexpected breakup opens up a chance for opposition parties to unite behind an alternative candidate for prime minister.

The “Takaichi trade” was initially driven by market expectations of Abenomics-style fiscal stimulus and slower rate hikes. The yen weakened sharply beyond the key psychological level of 150 per dollar, and Japanese equities rallied. Those gains partially reversed as the LDP–Komeito breakup increased uncertainty and concerns over legislative gridlock. Still, the Polymarket prediction platform gives a 77% chance of Takaichi becoming prime minister (down from an initial 99%).

We've charted consensus forecasts compiled by FocusEconomics to analyze how this uncertainty has shaped changing perceptions of the yen, Bank of Japan policy and 10-year benchmark government yields.

From September, analysts started expecting a weaker yen, reversing the firmer expectations seen between May and August during the US–Japan trade talks. Analysts are also expecting a less hawkish BoJ. Still, forecasts for the benchmark 10-year government bond yield continue to edge higher.

A Takaichi-led minority government would mean the the LDP needs cooperation with opposition parties to pass budgetary proposals. Takaichi has also pledged to strengthen Japan's defense and economic security. Although her tone on what was once an aggressive fiscal policy has softened, markets still expect expansionary spending -- which is generally seen as equity-friendly, but may weigh on bond markets due to rising fiscal risks.

Data from the US Commodity Futures Trading Commission (CFTC) further underlines the shift in sentiment, as our second chart shows; speculators have steadily reduced their net long yen positions since late April, signalling their fading conviction in yen strength.

Turning to fund-flow data from our partners at EPFR, we can see that foreign investors, who had paused Japanese equity fund investments following the July upper house election, have been rebuilding those positions; a weak yen generally favors Japanese equities.

As talks between the LDP and the Japan Innovation Party continue, potentially paving the way for Takaichi to secure the appointment, we conclude with a long-term look at Japan's dominant post-war party and highlight how coalition partners became so crucial to its survival: its approval ratings have steadily declined in recent years.

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