What outlook for the yen and pound?

Japan’s snap Lower House election result has vindicated PM Takaichi’s decision to try to increase her government’s majority. But it has not, so far, vindicated the view of yen bears that the sweeping win for the LDP will usher in a sharp fall in the currency.

Many remember how Takaichi’s apparent mentor, former PM Abe stormed to victory in 2012 and unleashed a sharp decline in the yen via the sort of fiscal easing that Takaichi is mimicking right now with plans for a temporary consumption tax cut on food.

Government debt is already high; there’s understandable concern that easier fiscal policy could unleash similar yen weakness this time around. But the key difference this time is the stance of monetary policy. For now, monetary policy is being tightened, and Takaichi’s victory might even lead to a tougher policy stance.

Back in 2012, PM Abe appointed Kuroda to be Bank of Japan Governor and he unleashed significant monetary policy accommodation via quantitative and qualitative easing (QQE). This is important because the combination of loose fiscal policy and tight monetary policy is supposed to deliver currency strength, while loose fiscal and loose monetary policy deliver the opposite. Loose fiscal and monetary policy brought about extensive yen weakness under PM Abe; just whether the opposite is the case now remains to be seen.

One problem with today’s story is that it is hard to describe Japan’s monetary policy as being ‘tight’ even if policy rates and yields are rising. For instance, real (inflation-adjusted) rates remain very low given that inflation has risen and rate hikes have rather lagged behind. This would seem to suggest that the BoJ will have to hike rates much more to effect a loose fiscal/tight monetary policy combination that could lift the yen materially.

Until then, Steven Barrow, Head of Standard Bank G10 Strategy suspected that the US dollar/yen won’t stray too far from a 155-160 range, with the BoJ forced to try to prevent excessive yen weakness by the threat of intervention, a threat that could easily become reality if the yen bears gain the upper hand. In time, as rates rise and the US dollar weakens, the US dollar/yen seems likely to fall back to the 140 region. But he sees this taking up to two years.

While the political situation looks good for the Japanese government, the opposite is the case in the UK. For here, the government is languishing in the polls, and Prime Minister Starmer seems to be clinging onto his job by his fingernails. Sterling has started to wobble and will likely accelerate its fall should Starmer resign or be forced out by a leadership challenge. However, what is important to remember here is not the identity of the PM, per se, but instead the implications of a change in leadership for fiscal policy.

“We saw that most clearly during the last Conservative leadership era. For here, we saw a number of leadership changes, from Cameron in 2010, through Theresa May and onto Boris Johnson, in often acrimonious circumstances, but without any major impact on the pound”, said Steven Barrow.

The one change that did produce a dramatic effect on sterling was when Liz Truss took over in September 2022. But this did not happen when she took over. Instead, the pound collapsed a short while afterwards because her chancellor, Kwasi Kwarteng presented a very injudicious budget.

In fact, most of the contentious measures in the budget had to be reversed and it was only when new PM Sunak came into power some 44 days after Truss was elected that the pound was really able to stabilise. The clear lesson from this is that it is not the identity of the new PM that is key but whether fiscal policy is undermined and, in the case of current PM Starmer, there are justified concerns that the government could shift to the left, with less budgetary discipline, and at a time when there is already unease over fiscal discipline.

This being said, Steven Barrow’s view is that if Starmer does go the new PM won’t mark a significant leftward shift in policy and any sterling weakness will prove modest and temporary; not deep and long-lasting. This being said, it is self-evident that any uncertainty over Starmer’s position right now, and the identity of a new leader should he go, will weigh on sterling sentiment for the time being.