Japan, long-term bonds plunge, stock market rises as next prime minister expected to expand fiscal spending

LDP, which lost its majority, expected to reflect opposition's demands for fiscal expansion

Front-runner Sanae Takaichi, former secretary-general, supports stimulus measures

Long-term Japanese government bonds plunged on the 8th (local time) after Prime Minister Shigeru Ishiba decided to resign. This was due to expectations that the candidates being mentioned as Ishiba's successors would push for fiscal expansion.

On the 8th, the yield on Japan's 30-year government bond rose by 6 basis points in one day (1bp=0.01%) to 3.285%. The 20-year bond yield reached 2.670%, up 3.5bp. Because bond yields and prices move in opposite directions, when bond prices fall, yields rise.

Japanese government bond investors expect long-term yields to rise further. This is because candidates from the LDP who lost a majority in the Diet are more likely to increase government spending more than Prime Minister Ishiba under pressure from opposition parties.

Shinichiro Kadota, head of Japan FX and rates strategy at Barclays Securities Japan, said, "Because the LDP and Komeito lost their majorities in both houses, they will have to cooperate with opposition parties that are calling for fiscal expansion." He added, "Therefore, regardless of who becomes the next prime minister, the (bond yield) curve is likely to steepen further."

Meanwhile, the Japanese stock market jumped 1.45% that day to 43,643.81 points on expectations of fiscal expansion measures.

In the LDP leadership election scheduled for early October, a leading candidate within the ruling party is Sanae Takaichi, former secretary-general, who placed second to former Prime Minister Ishiba in last year's LDP leadership race. She has said she will carry on Abenomics and supports economic stimulus measures. Shinjiro Koizumi, the former prime minister's son and the Minister of Agriculture, Forestry and Fisheries, who was one of the three final candidates in the last race, may also participate in the contest.

Like bonds in the US, UK and Europe, Japan's long-term bonds have been under sustained pressure due to concerns about future inflation, government debt burdens and the market's limited ability to absorb bonds.

Political uncertainty has also complicated the outlook for the Bank of Japan's (BOJ) monetary policy.

Currently, the October index swaps are pricing in a 21% chance of a BOJ rate hike in October, down from more than 50% last week. However, the short-term bond market rose as weaker-than-expected US employment strengthened expectations for a Federal Reserve rate cut.

If Japan's government bond yields surge, the impact on other countries could be significant. Experts noted that as one of the world's largest holders of foreign assets, additional rises in Japanese bond yields could attract overseas capital and increase volatility in global bond markets.

A 5-year Japanese government bond auction is scheduled later this week. As expectations for the timing of the next rate hike change, this auction is expected to provide a clue about investor demand for bonds. Auctions for 20-year and 40-year bonds are to follow in the coming weeks. Although the Japanese Finance Ministry announced it would reduce the size of ultra-long bond issuance, this reduction is unlikely to be enough to ease investors' concerns.

Guest reporter Jeong-ah Kim kja@hankyung.com