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Political risks driving EUR & JPY lower at start of the week

JPY: Heightened policy uncertainty in Japan continues to weigh on the yen

The yen has continued to trade at weaker levels overnight following the victory for Sanae Takaichi in the LDP leadership election at the weekend. USD/JPY hit a fresh high overnight at 150.70 although it has lost some upward momentum after yesterday’s outsized move when the pair rose by almost 2.0%. Market participants are now eagerly waiting to see if the election victory will lead to looser fiscal and monetary policies in Japan helping to support economic growth. The appointment of former Finance Minister Shunichi Suzuki as the new LDP Secretary General may help to ease some investor concerns over fiscal discipline. Former Prime Minister and Finance Minister Taro Aso, who was important in swinging LDP Diet members votes in favour of Takaichi in the second round of the election, was also appointed Vice President. Speaking overnight new LDP Secretary General Suzuki stated that “even those who favour expansionary fiscal policy do not believe it’s ok to ignore fiscal discipline completely”. In the run up to the election new LDP leader Takaichi has been touting “responsible fiscal activism” with an aim to lower the government debt/GDP ratio. She is initially planning to prioritize gasoline/light fuel tax cuts, support for SME wage hikes and refundable tax credits. Market concerns over looser fiscal policy under Takaichi have hit the long end of JGB market. The 30-year JGB yield rose by almost 20bps hitting a high at 3.35% overnight before falling back to a low of 3.24%. Results from a  30-year JGB auction held overnight helped to provide some support. The results revealed firm demand at higher yields with the bid-to-cover ratio coming in at 3.41 compared to 3.31 at the previous auction and 12-month average of 3.37.

At the same time, market participants are currently reassessing the outlook for BoJ policy. The victory for Takaichi has already prompted market participants to scale back expectations for further BoJ policy normalization bringing down yields at the short end of the JGB curve. Prior to the election victory for Takaichi the Japanese rate market was pricing in around 14bps of BoJ hikes at the next policy meeting later this month and 19bps of hikes by year end which has now been scaled back to only 5bps and 15bps respectively. The adjustment in pricing fits with comments from Etsuro Honda who advises Takaichi on economic policies. He told Bloomberg that “a rate hike in October is probably  difficult in my view” although “it depends on the macroeconomic environment, but I don’t see a problem if it’s raised by 25 basis points in December”. He also noted that “too much weakening of the yen will impact inflation and will keep it elevated. It’s a little hard to say what the desirable level is but if it goes beyond 150 it’s a bit too much”. Finally he stated that he told Takaichi “there’s no rush to change” the Joint Statement between the government and BoJ. Overall, those comments may help to help to ease some concerns over a bigger dovish shift in the outlook for BoJ policy and downside risks for the yen. However, there have been mixed messages from Takaichi’s close economic advisors. Reuters reported comments yesterday from Takuji Aida who suggested that Takaichi will likely tolerate another 25bps hike by January but on the condition that no further hikes are delivered until 2027. Heightened policy uncertainty is likely to continue to weigh on the yen in the near-term.                

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Source: Bloomberg, Macrobond & MUFG GMR

EUR: French political risks intensify weighing more heavily on euro

The euro has underperformed at the start of this week alongside the yen. It has resulted in EUR/USD falling to an intra-day low yesterday of 1.1652. Like the yen the euro has been undermined by the pick-up in political uncertainty in France and renewed concerns over fiscal and economic outlook. The sharp euro sell-off yesterday was triggered by the decision from French Prime Minister Lecornu to resign. However, he has since agreed to at least temporarily revoke his resignation after discussions with President Macron. He posted on social media that “at the request of the President of the Republic, I have agreed to hold final discussions with the political forces for the sake of the country’s stability. It will tell the Head of State on Wednesday evening whether this is possible or not, so that he can draw all the necessary conclusions”. However, it still appears unlikely that he will be able to reach an agreement in time. The largely unchanged cabinet appointed over the weekend has made an agreement even more challenging. Prime Minister Lecornu’s plans for only a slightly target for the next year’s budget deficit at 4.7% of GDP have also limited the room for compromise on fiscal policy. As a result of the latest political developments, the government will struggle to meet the deadline to file a budget by 13th October making it likely emergency measures will be needed to avoid a shutdown in January.

If Lecornu is unable to reach an agreement by Wednesday and resigns then it will leave President Macron with the option of choosing another Prime Minister or calling elections in an attempt to break the deadlock in parliament. One option would be to choose another technocrat PM to pass a budget for next year. Downside risks for the euro would increase if parliamentary elections were called before the end of this year extending the period of political uncertainty. It would make it less likely that EUR/USD would rise up to our year-end target of 1.2000 although we are not convinced parliamentary elections would be sufficient on their own to trigger a sustained reversal of the strengthening trend for the euro that has been in place for most of this year.

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Source: Bloomberg & Investing.com