FX Weekly

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Tariff political risks for the yen

FX View:

The financial markets remain calm despite a weak of increased tariffs effective 1st August that have been sent to numerous countries. With some key countries not included and with expectations that deals can still be done before 1st August, the market fallout has been limited. Indeed, the S&P 500 hit a new record closing high this week. Where there has been some sign of FX reaction has been in USD/JPY with the yen the clear underperformer this week following a 25% tariff and reprieve for the auto-sector. Japan’s Upper House election takes place on Sunday 20th July and is complicating the government’s ability to reach a deal. We assess the election risks and the scenarios and the implications for reaching a deal. Some of the recent JPY underperformance appears political risk premium driven. We also assess the outlook for the pound following GDP data today that showed a 0.1% contraction in growth in May. While the data was not as bad as it looks (March GDP was revised higher) the risks to the pound remain skewed to the downside. Job market and CPI data will be key but there is an increased risk of the BoE upping the pace of rate cuts if the job market data points to continued weakness.

RBA HOLD PUTS AUD ON TOP WITH JPY LAGGING AGAIN

Source: Bloomberg, 13:00 BST, 11th July 2025 (Weekly % Change vs. USD)

Trade Ideas:

We are maintaining our long EUR/GBP trade idea to reflect both the loss of growth momentum in the UK and pick-up in fiscal concerns.

JPY Flows:

This week we look at the monthly Transactions in International Securities data for June released by the MoF this week. June saw another strong month of buying of foreign bonds driven by Japan Trusts.

A Quantitative Approach to TACO:

FX markets initially reacted strongly to Trump-era tariffs, but investor sensitivity has faded. Our analysis warns FX markets may be under-pricing policy risk amid rising complacency.

FX Views

JPY: Upper House elections could trigger JPY selling

The yen is by some distance the worst performing G10 currency this week – down 1.7% with the euro the next worst, down 0.7%. On a month-to-date basis it is also the worst performing, down 2.1%. The initial move higher for USD/JPY came after the US jobs report on 3^rd July and while we believe the report wasn’t particularly positive, expectations had been for a weak report and hence US yields and USD./JPY rallied. A bigger move for USD/JPY then came from the US tariff announcements on Monday with Japan one of the first countries to get a letter confirming a 25% tariff on all goods outside of those goods already hit by sector-specific tariffs, like the 25% on autos. Investors have been reacting modestly to these tariff announcements on the view deals can still be done by the 1^st August deadline. However, the current approach of the Japanese government creates greater uncertainty. The Ishiba government are insisting on lower auto tariffs before agreeing to any other deal which could create issues for the Trump administration and adds risks of no deal being done. On Tuesday, Japan’s lead negotiator, Ryosei Akazawa stated that the auto sector is a core industry and the US tariffs are causing “tremendous daily losses to Japanese companies” and went on to add that “unless there is an agreement …. regarding that sector, I don’t believe it would be possible to reach an overall agreement as a complete package”.

The stance being taken by Japan looks risky and it seems unlikely to endear Trump to reaching a deal.  Apart from the UK with a quota-related 10% tariff on autos and for Mexico and Canada under the USMCA deal there are no other countries with a carve-out to the sector-specific auto tariff. Japan likely want what the UK has but are at risk in getting nothing. This tough approach by Japan may well reflect concerns over the upcoming Upper House election. Normally these elections can pass without much financial market implications, but this time could be different. Given the already precarious position of the Ishiba administration, operating as a minority government in the Lower House, a poor result in the election on Sunday 20^th July could prove a disaster for the administration with Ishiba forced to resign.

The Upper House has 248 seats, with a majority of 125 required but 75 Upper House seats held by the coalition will not be contested meaning the coalition government requires 50 of the seats being contested. 125 seats in total are being contested – 74 seats from prefectural constituencies; 50 seats through proportional representation and one additional vacancy in the Tokyo electoral district. A Yomiuri Shimbun poll conducted last Thursday and Friday, indicated the possibility of the LDP-New Komeito coalition winning only 40 seats mainly due to some poor performances in the prefectural constituencies. A number of constituencies show the LDP running 50-50

versus the main opposition party, the Constitutional Democratic Party of Japan (CDPJ). Of the 52 LDP seats contested, the 32-single seat districts will be key and is where the LDP has tended to perform well previously. Of the 32 seats, the LDP is leading in only 12 seats, while opposition candidates are ahead in 9 seats and the remaining 11 seats are too close to call. Asahi projects the LDP winning about 27 prefectural seats and 12 proportional seats with New Komeito winning 10 of its 14 contested seats. This result would be one short of what’s required and hence the government would lose its majority. Our sense is that there’s a slightly greater than 50% chance of the government losing its majority.

JPY THE WORST PERFORMER IN G10 IN JULY TO DATE

Source: Bloomberg, Macrobond & MUFG GMR

 HIGH ECONOMIC POLICY UNCERTAINTY FOR JAPAN

Source: Bloomberg, Macrobond & MUFG GMR

A loss of the current majority would mean that both the Lower House and Upper House would be short of a government majority, both of which has happened under PM Ishiba’s rule and this outcome would severely damage the credibility of the prime minister. However, there is no formal process for removing the PM although there would certainly be an increased probability of PM Ishiba resigning. A familiar field of candidates exist to take over if Ishiba did resign. The one potential winner that could have market implications is Sanae Takaichi. She got to the final run-off against Ishiba with the result 52.6% vs 47.4% (215 votes to 194) so could be well positioned and would be one of the favourites. This could be a factor undermining the yen given she was closely aligned with Shinzo Abe and his Abenomics policies. If Ishiba does not resign, an attempt to broaden the coalition is one possibility although the history of larger coalitions is not a good one and investors would price for political instability.  

Scott Bessent and Howard Lutnick will be in Osaka next week for the World Expo 2025 to celebrate US National Day. There is of yet no formal plan to meet with Akazawa to negotiate further. Given this would be just prior to the election, Akazawa would likely thread carefully with little chance of the US ceding ground on auto tariffs. The post-election status could also prove complicated. If PM Ishiba is left weakened or of course is forced to resign, the political landscape will be very difficult for any meaningful negotiations to take place. The best scenario in which the government could cede ground and make a deal would be if the LDP-New Komeito manage to maintain its majority. Such a result would lift expectations of a deal and help strengthen the yen.

A loss of majority in the Upper House election for the government and the resignation of PM Ishiba would lift expectations of a Takaichi leadership victory which would likely see yen selling intensify. A poor election result leaving the government further weakened could see less intense yen selling while maintaining its Upper House election majority would likely see USD/JPY retrace much of this week’s losses.

UNUSUAL SCENARIO – MUFG REGRESSION FAIR-VALYE MODEL INDICATES USD/JPY UNDERVALUED BY 5%

Source: Bloomberg & MUFG GMR

DEPRESSED CONSUMER CONFIDENCE HIGHLIGHTS ELECTION RISK FOR GOVERNMENT

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Balance of risks is beginning tilt to the downside for GBP

The GBP has been consolidating at lower levels over the past week following last week’s sell-off triggered by renewed concerns over the UK public finances. After hitting a high last week of 0.8738 on 11^th April, EUR/GBP has continued to trade above the 0.8600-level this week. It is the longest period EUR/GBP has held above the 0.8600-level since late 2023/early 2024. Similarly, GBP/USD has dropped back towards support at the 1.3500-level after hitting a high of 1.3789 on 1^st July. The correction lower for cable has been driven as well by the broad-based rebound for the USD so far this month.              

Last week’s GBP sell-off was triggered by speculation that Chancellor Reeves could be replaced adding to fiscal risks and political uncertainty in the UK. It followed another embarrassing u-turn for the government who were forced into watering down their plans for welfare reform. Prime Minister Starmer quickly delivered  a vote of confidence in Chancellor Reeves which has helped to dampen speculation over her immediate future. However, doubts remain over the government’s plans for fiscal policy with tax hikes likely to be needed in the Autumn Budget. At the same time, the release this week of the OBR’s latest report on fiscal risk and debt sustainability has emphasized  the relatively vulnerable position of the UK’s public finances. At the end of 2024, the OBR highlighted that the UK’s public deficit was around 4ppts higher than the advanced-economy average. Similarly the 10-year government bond yield in the UK is the third highest amongst advanced economies. The OBR noted that past efforts to put the UK public finances on a more sustainable footing have had only limited and temporary success in recent years. The lack of fiscal consolidation reflected  governments reversing planned tax rises, and more significantly, abandon plans for spending cuts.              

On the one hand the GBP has been benefitting from the higher yields on offer in the UK which has helped to boost its carry appeal. The gradual pace of BoE rate cut has helped to keep yields in the UK amongst the highest on offer for G10 FX. However, there have periods like last week when rising yields at the long end of the curve driven by UK fiscal concerns have flipped to become negative factor for the GBP. The correlation between GBP performance and long-term gilt yields has become more negatively corelated in recent years since the mini-Budget shock in autumn 2022 that brought an end to former Prime Minister Liz Truss and her Chancellor Kwasi Kwarteng. While we are not expecting a repeat for the current UK government this autumn, they will be under pressure announce credible fiscal tightening measures to prevent another sell-off in the gilt market and for the GBP.

CARRY HAS BECOME LESS IMPORTANT DRIVER

Source: Bloomberg, Macrobond & MUFG GMR

GBP MORE NEGATIVELY CORRELATED TO GILT YIELDS

Source: Bloomberg, Macrobond & MUFG GMR

In the interim building expectations for tax hikes could create an additional headwind for growth by discouraging households and businesses from spending. The latest monthly GDP data for Q2 provided further evidence that the UK economy slowed sharply in Q2 following strong growth in Q1. Real GDP contracted for the second consecutive month in May. Our European economist is currently estimating economic growth of +0.2% in Q2 down from +0.7% in Q1 (click here). Growth was boosted in Q1 by front-loading ahead of tax hikes and tariffs with payback weakness in Q2. The UK economy is  following last year’s pattern of strong growth at the start of the year which then faded over subsequent quarters perhaps suggesting some ongoing problem with seasonal adjustments. If slowing growth momentum continues through the 2H of this year it should give the BoE more confidence that slack is increasing in the economy and help to dampen their outlook for inflation.

One positive for the UK economy which is helping to dampen downside risks to the growth outlook has been the recent trade deal announced between the UK and US. The trade deal has prevented a bigger increase in tariffs applied to imports from the UK into the US. The minimum 10% tariff will remain in place while sector specific tariffs on autos were reduced from 25% to 10% for exports up to 100k vehicles per year, tariffs on the UK aerospace sector were eliminated and work is ongoing on imposing a quota for steel and aluminium imports that would be exempt from 25% tariffs. Unlike other countries the UK was not subject to the higher 50% tariffs applied to steel and aluminium.  According to media reports, the EU is moving closer to securing a UK-type trade deal with the US that would further dampen downside risks for growth in the UK.    

For the BoE when setting monetary policy they will have to weigh up slowing growth momentum for the UK economy against reduced downside risks to the growth outlook from trade disruption. The BoE have indicated recently that they are becoming more concerned by the softening UK labour market. At the last MPC meeting in June the BoE acknowledged that payrolled employees had declined so far in 2025. The BoE staffs’ own measure of underlying employment growth suggests a subdued rate of near-zero employment growth. A further fall in payrolled employment in next week’s UK labour market report would reinforce expectations for BoE rate cuts, and would challenge the BoE staffs’ view that there are no strong signs yet that a more abrupt loosening is underway. The BoE’s reluctance to deliver faster rate cuts reflects unease over the elevated service sector inflation which has been running at around 5.0% this year. Next week’s UK CPI report is not expected to provide much relief for the BoE.         

In light of recent developments, we recommended a new long EUR/GBP trade recommendation last week (click here) to reflecting UK fiscal risks and slowing cyclical momentum for the UK economy that could encourage the BoE to speed up rate cuts. 

UK BUDGET DEFICIT REMAINS RELATIVELY HIGH

Source: OBR Fiscal Risks & Sustainability Report July 2025

LONG GBP POSITIONS HAVE BEEN POPULAR

Source: Bloomberg, Macrobond & MUFG GMR

Weekly Calendar

Source: Bloomberg & MUFG GMR

Key Events:

• It will be an important week for UK economic data releases in the week ahead including the latest CPI report for June (Wed) and labour market report (Thurs). The data releases will be watched closely to assess if the BoE remains on track to cut rates again at the next MPC meeting in August. The UK rates market is currently pricing in the BoE sticking to the quarterly pace of rate cuts through the rest of this year. For the BoE to speed up the pace of rate cuts in the 2H of this year it will require more evidence of loosening labour market conditions. PAYE payroll employment has contracted by around 230k in the first five months of this year which is beginning to attract more attention from MPC members. Chancellor Reeves and BoE Governor Bailey are also scheduled to hold their annual Mansion House speeches on Tuesday evening. Chancellor Reeves is expected to deliver a speech on pensions and investment reform in the UK. The topic of discussion from Governor Bailey is unclear. He recently opened the door to slowing the pace of QT from September and continues to emphasize guidance for gradual rate cuts.

• Elsewhere, market attention will be on the latest inflation updates from Canada, Japan and the US. The recent pick-up in core inflation in Canada has encouraged the BoC to become more cautious over cutting rates further in the near-term as they continue to weigh up the economic impact of trade tariffs with the US. Unless core inflation drops back next week the Canadian rate market is unlikely to significantly bring forward expectations for another BoC cut to as soon as the end of this month. Similarly, the Fed are expected to leave rates on hold this month as they wait for evidence of the inflationary impact from tariff hikes. Inflation is expected to pick-up due to tariff hikes but the disinflation trend remained in place for the first five months of this year. In contrast, market expectations continue to weigh up the need for further BoJ rate hikes in response to above target inflation. A shortage of rice is contributing to higher inflation. The threat of 25% tariffs for Japan from 1^st August favours the BoJ maintaining a cautious stance.