The Japanese yen rose sharply on Monday after the results of Japan’s Upper House election. Prime Minister Ishiba’s ruling coalition lost its majority, leading to expectations of political uncertainty as they now lack control in both the upper and lower houses. Initially, the yen fluctuated, rising, then pulling back, before gaining again during European and US trading hours. Japanese Government Bonds (JGBs) and equity futures did not show much movement as the markets reopened after a holiday. Early signs suggest minimal changes in response to the political changes.

Legislative Gridlock

The loss for Ishiba’s coalition signals potential legislative gridlock, making new fiscal stimulus unlikely. This could hinder domestic growth, especially after the Cabinet Office recently lowered its GDP forecast for the current fiscal year. Derivative traders should prepare for a time without government-led economic support. The yen’s strength, which pushed the USD/JPY pair down from its recent 34-year highs above 160, makes sense in light of this new situation. With a reduced chance of large fiscal spending that could weaken the yen, it may stabilize. We anticipate increased yen volatility, making long yen option strategies more appealing.

Nikkei 225 Risks

We think the subtle reaction in equity futures hides a growing risk for the Nikkei 225 index. An ineffective government might struggle to pass pro-business reforms or spending packages, which are crucial for corporate earnings. This environment suggests buying put options on the index to prepare for potential declines. The slight change in government bonds shows that the Bank of Japan, rather than the government, is still the main driver for JGBs. With the 10-year yield kept near 1% due to monetary policy, the election results are mainly a non-event for this market. Traders should pay attention to the central bank’s next meeting for guidance, rather than political news. Historically, periods of a “twisted Diet” in Japan, like after the 2007 election, have resulted in policy stagnation and market drift. This history suggests we should not expect any significant government actions that would impact the markets. Implied volatility in equity options might not be reflecting the risk of ongoing indecision adequately. Create your live VT Markets account and start trading now.

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