Market Update - Fiscal concerns after Japan election keep JPY and JGBs volatile despite trade deal

Highlights: Political uncertainty and fiscal risks in Japan persist after the ruling coalition lost its majority in the Upper House election. We expect Japan’s fiscal policy will likely turn substantially more expansionary while the path to the Bank of Japan’s (BoJ) monetary normalisation becomes more uncertain. While the US and Japan have reached a trade deal to lower reciprocal tariff rate to 15 per cent from 25 per cent, fiscal concerns will add volatility to the JPY and Japanese government bonds (JGBs). We stay neutral on the JPY and Japanese stocks and remain underweight on JGBs.

• Policy implications: After losing a majority in both parliamentary houses, the ruling coalition will need to compromise further with the opposition parties to pass key legislation. Japan’s fiscal policy will likely become substantially more expansionary, as the opposition parties have pushed for aggressive fiscal spending such as cash handouts and consumption tax cuts
• JPY (Neutral): The US-Japan trade deal will ease near-term pressure on the JPY, but the uncertainties surrounding LDP leadership, BoJ’s policy normalisation path, and fiscal challenges will likely keep the JPY volatile within our modelled trading range of 145-152. On a 6-month horizon, we stay neutral on the JPY based on our expectations of one rate hike by the BoJ in October and two rate cuts by the Fed in September and December 2025. We expect USD/JPY will likely trade back towards our end-2025 target of 140 with a weaker USD in Q4
• JGBs (Underweight): Japanese government debt level remains the highest in the developed world at about 250 per cent of GDP. Key opposition parties are calling for further increase in JGBs issuance to finance more aggressive fiscal stimulus. Concerns about fiscal sustainability will likely keep JPY rates volatile and term premium in long-end JGBs elevated
• Japanese equities (Neutral): The trade deal will lower US reciprocal tariff rate to 15 per cent from 25 per cent, supporting recovery of Japan equity sentiment. We stay neutral on Japanese stocks amid continued reflation trend and rising expectations of fiscal stimulus to boost domestic consumption. We favour Japanese technology leaders and consumption related stocks