The Flip Side podcast – Episode 77

Brad Rogoff:
Welcome to The Flip Side. I’m Brad Rogoff, global head of research. And joining me today from Tokyo is Shinichiro Kadota, our head of Japan FX and rates strategy. Shin, it’s great to have you on.Welcome to The Flip Side. I’m Brad Rogoff, global head of research. And joining me today from Tokyo is Shinichiro Kadota, our head of Japan FX and rates strategy. Shin, it’s great to have you on.

Shinichiro Kadota:
Thanks for having me, Brad, and glad we found a time that works for folks Tokyo and New York.

Brad Rogoff:
Well, look, I feel like we had to because, well, it’s always relevant what’s going on in Japan to global markets, especially global fixed income markets. When I look at the 77-episode arc so far of The Flip Side, right now is probably the most relevant time in terms of being able to actually have a real debate on something that’s going on in the country, considering the pivotal moment we’re in following the recent elections.

So what I want to examine today is how Japan can balance the legacy of Abenomics against mounting global pressures. New PM Takaichi is a strong follower of Abenomics like high pressure economy with inherent bias for proactive fiscal and close BOJ government coordination. In her victory speech after the Liberal Democratic Party, or the LDP as it’s known, presidential election, she argued that Japan has not fully escaped deflation yet and even touched on potentially reviewing the BOJ government accord. To me, that sounds like a full-on doubling down on Abenomics.

Shinichiro Kadota:
So while I agree that the PM Takaichi’s inherent bias is for doubling down on Abenomics, both the market and the political environment that PM Takaichi faces today is vastly different from what late PM Abe faced in 2012. So today, the yen’s half the value against the dollar. Since then, Japan’s general public didn’t like it, and the US administration has also noticed it. And additionally, super long JGB yields have reached highest levels in history. And politically, former PM Aso was the kingmaker of PM Takaichi in the latest LDP election, who became the vice president of the LDP. And also, his brother-in-law, former Finance Minister Suzuki became secretary general of the LDP.

With the text from these fiscally disciplined senior leaders, I think PM Takaichi is unlikely to pursue reckless fiscal policy, and these market and political pressures are forcing policy adjustments that diverge from classic Abenomics. And that is why I think that you will see a redefinition of Abenomics in a much less extreme manner.

Brad Rogoff:
Well, thank you. Now we got the whole family tree there, it sounds like. But let’s just start with talking about how big the stakes are and how immediate the consequences can be. So if fiscal intent outpaces market tolerance, then consumers will have to pay a credibility tax, usually that occurs through FX, inflation and the long end. So if policies underdeliver though, then confidence erodes anyways.

Shinichiro Kadota:
Yep. So you mentioned the consequences. And I agree with the tape on this one. So the early reaction was equities higher, JGB long yields higher and the yen weaker. Some of it faded as investors realized pulling together a big package fast is hard. The rhetoric is now somewhat of a smaller, bit slower and more conditional one. That’s the real definition.

Brad Rogoff:
Let’s talk about fiscal here. So during the LDP presidential election, Takaichi campaigned on targeted tax relief, local government support and investment and did not deny the possibility of increasing deficit funding JGB issuance, unlike what the other candidates actually did. After forming a coalition with JIP, she agreed to consider lowering food consumption tax and subsidizing high school education as a minority government. And with Takaichi’s inherent bias, isn’t the path of least resistance more expansionary fiscal policy, which can reverse the tape you’re talking about?

Shinichiro Kadota:
So, yes, I agree that the fiscal policy will be more expansionary under Takaichi than say her other opponents, such as Koizumi. And indeed, the market heard the expansion and moved reflexively. However, she faces the market and political constraint, as I mentioned earlier, and her argument for responsibly active fiscal policy and calling for lower net government debt to GDP ratio is a bit different. And we estimated that the initial policy proposals would export about 15 basis point upward pressure on 30-year JGB term premium.

We also estimated that the further super long JGB issuance could reduce the term premium by ten basis points, leaving the net impact to a mere five basis points. So in practice, I think that means conditional stimulus and the calibrated rollout, not the early Abenomics type of bazooka, which drove the sharp market reaction, like Dall-E[?] and going from 80 to 100 in just six months of his election victory.

Brad Rogoff:
So yeah, I agree. Five basis points of upward term premium not the end of the world, but that upward pressure that you’re referring to on term premium here is policy related. Right. But isn’t there also a structural lack of demand in super long JGBs, and how does that fit with your argument for this relative stability you’re mentioning?

Shinichiro Kadota:
Yeah. So the demand factor is definitely something we have been focused on quite a bit recently. And due to the demographics and the regulatory backdrop, life insurance who were the main buyers of the super long JGBs for a long time have basically stopped buying in the recent years. And that is unlikely to change the amount of you. And now the main buyer of the super long JGBs have basically shifted to pension funds, which is doing it for the rebalancing purposes due to the strong equity performance.

And the other key buyer is foreign investors. And but neither of them are really stable source of demand for JGBs. And that is why the JGB issuance cuts are in the focus. The Ministry of Finance have already cut the issuance by about ¥4 trillion in the summer. And additional cuts could help restore the balance in the supply and demand. So I think that in turn, could stabilize JGB term premia in at least in the near term.

Brad Rogoff:
Okay. So that’s the demand side. But going back to fiscal policy, even a smaller package can certainly matter, especially with coordinated BOJ messaging. In fact, Takaichi is calling for more fiscal policy beyond just next year, including refundable tax credits, food consumption taxes, as well as further increases in defense spending.

Shinichiro Kadota:
Agreed. But they will only go through with the if credibility holds. And the catch is credibility is mark to market every day and FX and yield curve as there is always a risk of inviting oversized market reaction that will ultimately tie her hands, as was the case for the UK in 2022. And Japan is much more similar to UK than meets the eye.

Brad Rogoff:
How is that so, Shin? Because that’s not completely obvious to me.

Shinichiro Kadota:
So although Japan differs from UK in lacking super long leveraged by pensions and having lower foreign holdings of the JGBs, its supply and demand dynamics like the UK remains fragile, driven by structural weakness in life insurance demand and growing share of foreign trading. Hence, we believe any policy error could lead to an outsized market reaction that will ultimately constrain Takaichi’s hands.

Brad Rogoff:
I’d buy some of that. Maybe I’ll have to ask one of our UK guys next time we have them on The Flip Side, if they think they’re similar to Japan. So let me now turn to part of Takaichi’s argument, which is that to implement her policy deficit funding JGBs will be used if needed. Once again, that was very different than what other LDP candidates said. So she even mentioned possibly reviewing the government BOJ accord in her LDP election victory speech, which all suggests to me at least her Abenomics style is very well intact.

Shinichiro Kadota:
Sure. But let’s look at an example of what could happen when those market forces can limit actions and ultimately the outcomes. So one example is back in July 2016 when Ben Bernanke, who was writing kind of all about helicopter money in his blogs, visited then the PM Prime Minister Abe, which then raised expectation that Japan might adopt such a policy. And this has led to 25 basis point steepening in 1030 JGB curve, 6% yen depreciation against the dollar in just a matter of just a week or so. Of course, Japan did not adopt those policies eventually. And but Takaichi’s Abenomics leaning comments could lead to such an expectation speculation and derive significant near-term market volatility, which could eventually constrain the ability to implement such extreme policies, in my view.

Brad Rogoff:
All right. I talked about the BOJ. You just brought our friend Mr. Bernanke into the conversation. So let’s talk a little bit more about central banks here. So one topic that’s come up on this podcast and many others is the general concept of central bank independence. Not necessarily with respect to Japan, but other places including the US. So on its face, inflation is sticky enough to keep that conversation alive, but the Prime Minister is likely to lean against hikes. So is this a sustainable equilibrium here?

Shinichiro Kadota:
Sure. Well, Prime Minister Takaichi clearly has a dovish bias on the BOJ. We believe the macro and external environment would allow the BOJ to continue its policy normalization. First of all, Japan’s core inflation has overshot its target, 2% target for more than three years now. Second, a lack of hike could accelerate the yen depreciation, which has been very unpopular among the Japanese public as a cause of inflation, and importantly, US administration has criticized yen weakness in the past and called for continued BOJ policy normalization as recently as Bessent’s comment in the last week. And in fact, US Treasury reiterated this message that the sound monetary policy is important in anchoring inflation expectations and preventing excess FX volatility.

Brad Rogoff:
Well, now we’re getting even more relevant for global markets here certainly. One thing I could see is convenient argument that it’s too early to declare a clean exit from deflation psychology, and that helps appease the new PM.

Shinichiro Kadota:

Governor with his cautious stance and need for coordination with the new administration, that suggests that a delayed hike compared to what is priced in the market. Our call is that there will be a hike in January. However, we believe the BOJ’s rate hiking cycle isn’t dead under Takaichi due to the different macro and diplomatic conditions I mentioned earlier. If yen depreciates more quickly, then the BOJ is likely to respond with even earlier hikes.

Brad Rogoff:

So I alluded to this earlier, right, in terms of the global implications we have from Japan. But one of the biggest ones is that Japan has been a large international bond investor. So at some point, a rise in domestic yields kind of has to spill over to global rates due to their repatriation back to home markets. Right?

Shinichiro Kadota:
Yeah, I agree to an extent, but I believe the near-term impact will be limited as Japanese investors have already sold a significant amount of foreign bonds in 2022, 2023 during the global duration sell off and rising FX hedging costs for domestic investors. In the near term, some investors are even thinking about buying some foreign bonds again, just given the expectation for lower FX hedging costs as the Fed continues to cut its policy rate. However, you’re right in saying that the Japanese investors will surely keep more funds in domestic bonds now because now the yields are high enough to cover their liability costs instead of having to chase foreign bonds forward carry. So meaning I think what it means is the new money will stay more in Japan. So probably less demand for foreign bonds in the future for sure.

Brad Rogoff:
But if we’re forward looking and the Fed’s cutting and the BOJ is likely to continue hiking, wouldn’t that be positive for the yen?

Shinichiro Kadota:
So you’re correct that the timing rate differential should drive the dollar yen lower. However, I think there’s a good argument that the BOJ hike to 1% and the Fed cutting to 3% are already well priced in the market. And additionally, Dalian[?] has not really been driven by rates since 2024 as it kept rising towards 160 despite stable rate differentials. And the driver of yen weakness since 2024 has been global equity risk premium. So basically, the strong equity performance has been reducing demand for safe haven currency like the yen. And this can cause the yen to weaken further even from the current level, despite the consensus forecast of 140.

Brad Rogoff:
Okay. But you’re the expert on Japan. But even I know that this is Japan, and we’ve seen FX intervention on currency sell offs in the past. So if the Ministry of Finance steps in, do you think that makes prolonged yen strength more likely?

Shinichiro Kadota:
Innovation can shift levels and break momentum in the short term, but it rarely reverses the broad trend. We believe the fundamental driver of higher dollar yen is US exceptionalism. Outperformance of the US economy drives dollar strength, a strong equity rally that weighs on the yen via safe haven channel and drives the structural deficit for Japan. In fact, Japan runs a deficit of more than 1% of GDP, particularly against US mega digital companies.

Brad Rogoff:
So we talked a lot about market based and political constraint, but Takaichi was able to form a new coalition quickly, and after the LDP’s long standing partner, Komeito decided to leave her. So wouldn’t that put her in a stronger position to actually pursue her policy agenda?

Shinichiro Kadota:
So while she quickly recovered ground, to your point, the new coalition is still short of commanding a majority in both houses. So, however, to your point, there’s one risk that can tip the balance towards your scenario, which is the snap election. So PM Takaichi’s administration’s inaugural approval rating hit 71%, according to Yomiuri Newspaper, which is the fifth highest in history. And hence, the PM Takaichi may decide to call an early snap election maybe around the end of this year, maybe around the end of fiscal year perhaps after passing the budgets. And if LDP wins strongly in that election, she will have a much stronger political mandate to pursue her own policy agenda.

Brad Rogoff:
That would certainly keep Japan at the forefront of global markets. And we’ll be watching closely as the story continues to unfold. That’s a wrap for episode 77 of The Flip Side. Thanks for tuning in. Subscribe wherever you get your podcasts, so you never miss a debate. Barclays Investment Bank clients can explore Japan’s macro strategy in depth with our latest reports, including impact of economic policies on JGB term premium, and a topic that we didn’t even get to dig into that much, US-Japan investment deal and market implications now available on Barclays Live. Until next time, see you on The Flip Side.