【Japan】Post-House of Representatives Election Market Outlook… LDP Victory Main Scenario, But ‘Not Straightforward’ Possibility… What is the ‘Negative Surprise’ Investors Fear? [Fund Manager’s View]

From late January to early February, the markets were extremely volatile. The new Federal Reserve Board (FRB) chair became clear, and a rapid strengthening of the US dollar and significant declines in precious metal prices occurred, driven by the unwinding of so-called de-basement trades (trades to avoid the negative effects of a weak domestic currency).

While the direction of capital flight from the US dollar is a very interesting investment theme, the priority is the House of Representatives election on February 8th. This report’s theme is ‘Market Fluctuions to Anticipate Post-Election, Just Before the House of Representatives Election,’ making it a very time-sensitive report.

For the weekend’s House of Representatives election, while reports suggest a strong victory is expected with the Takai cabinet maintaining high approval ratings and the Liberal Democratic Party (LDP) securing a single-party majority, the opposition landscape has changed, making vote predictions more difficult than usual. It is fully conceivable that the actual result could be a surprise.

Broadly categorizing the election results, the following three scenarios are considered likely.

[Three Scenarios for the House of Representatives Election]

1. LDP Landslide Victory (Securing 233 or more seats for a single-party majority)
2. Status Quo (Maintaining the LDP-Komeito coalition government)
3. LDP Major Defeat / Change of Government

It is thought that the stock market would react positively to scenarios where the LDP wins (1, 2). However, the reaction of the bond and foreign exchange markets is likely to depend on the subsequent government’s stance on fiscal policy. Few market participants are believed to have scenario 3 as their main scenario; if it materializes, it would be a major surprise. While anticipating the market’s reaction is difficult, it is thought that at the very least, stocks would react negatively, and the bond and forex markets, influenced by the risk-off sentiment from the stock market, would initially see lower interest rates and a stronger yen.

Let’s check how the market views the situation as of early February. First, Japan’s bond market is surprisingly calm at the moment. Immediately after the dissolution announcement, long-term interest rates fluctuated wildly due to fiscal concerns when discussions about tax cuts became active. Currently, however, Japan’s 10-year government bond yield is hovering around 2.25%. The volatility priced into near-term one-month options has also calmed down, suggesting the options market does not anticipate major interest rate fluctuations ahead of the election.

While major Japanese stock indices have recently hit all-time highs, concerns about a correction are believed to be persistent due to the rapid pace of the stock price rise. Furthermore, unstable movements in the forex market and the fact that the stock price rise was driven by expectations for the snap election and fiscal policy are also considered reasons for the persistently high volatility.