Weak governments usually go hand-in-hand with weak currencies. But the electoral enfeeblement of Shinzo Abe’s administration in Japan may strengthen the yen.
At first glance, investors shouldn’t care much about Abe’s crushing defeat in Sunday’s upper house elections. The Liberal Democratic Party did even worse than expected, winning less than 40 of 121 contests, but voters didn’t seem to be protesting the government’s reform agenda. Even if they were, the pace of reform has been glacial, so any change would hardly be noticed.
As for interest rates, the election results shouldn’t matter, since rates are set by the independent Bank of Japan, not the government. But most observers think that the doves in the central bank have been strengthened by the government’s resistance to higher rates. The post-election resignation of Hidenao Nakagawa, leader of both the party and the anti-hike rhetoric, could give the hawks more ammunition.
In turn, the more immediate prospect of higher Japanese interest rates would frighten foreign investors who have been borrowing in yen in order to invest in higher-yielding currencies. The growth of this so-called carry trade explains a good part of the Japanese currency’s weakness—a drop of 10% against the dollar in the year before global markets started to wobble in mid-June.
Those wobbles dented the appeal of the carry trade, even before the election. In the last month, the yen gave up about half of the previous year’s gains. Investors started to shun all risks and US rate cuts started to look a little more likely. Now the potential gains from the carry trade are also being cut from the Japanese side.
If global optimism was still in full swing, the post-election focus would be quite different. Japanese domestic investors would be seen as losing confidence in the local economy, and more likely to sell yen in order to invest overseas. But when the market winds change, investors’ arguments follow.
The carry trade could give way to the fundamental trade, changing the focus to Japan’s huge trade surplus and minimal inflation. The yen could be a rock in troubled markets.