Shi Po unexpectedly elected as the President of the Liberal Democratic Party of Japan, will he clear the way for the Bank of Japan to raise interest rates?

According to the Zhitong Finance and Economics APP, on September 27th, former Secretary-General of the Liberal Democratic Party of Japan, Shigeru Ishiba, won the majority of votes in the second round of the LDP presidential election and was elected as the new president of the Liberal Democratic Party. As per tradition, the newly elected LDP president, Shigeru Ishiba, will be nominated in the National Diet election on October 1st to succeed as the Prime Minister.

At the age of 67, Shigeru Ishiba is a veteran of the Liberal Democratic Party and has held various senior positions including Defense Minister. With strong support from ordinary party members, Shigeru Ishiba defeated Sanae Takaichi in the LDP presidential election.

It is understood that with the current Prime Minister Fumio Kishida announcing last month that he will not seek re-election, a record nine candidates participated in the LDP presidential election. Kishida's approval ratings declined due to party bribery scandals and Japan facing challenging inflation.

Shigeru Ishiba is scheduled to hold a press conference in Tokyo around 6 p.m. local time. Given that the ruling coalition led by the LDP holds a majority in both houses of the Japanese Diet, Shigeru Ishiba, as the leader of the largest ruling party, is expected to be elected as the 102nd Prime Minister of Japan in the extraordinary Diet session on October 1st through the Prime Minister nomination election, succeeding the current Prime Minister Fumio Kishida.

Facing Numerous Challenges

As Japan emerges from three decades of stagnation and faces increasing diplomatic and security challenges, the new Prime Minister will need to lead the country through a period of transition.

Signs of recovery in the world's fourth-largest economy have reignited enthusiasm for Japan as a global investment destination. Wages and prices have started to grow, the stock market is returning to its highest levels since the 1980s, and the central bank is gradually phasing out unconventional monetary stimulus measures.

However, the new Prime Minister will still have to address ongoing deep-seated structural issues, particularly aging and shrinking population, persistently low productivity levels, and economic disparities. Geopolitical factors will also require the attention of this new leader.

With a national election expected to be held next year—likely as early as next month, candidates are seeking to attract the public by proposing measures to increase income and accelerate economic growth.

Other pressing issues facing Shigeru Ishiba include the need to establish cooperative relations with the United States and the incoming new president who will replace Biden in the November presidential election. The United States is Japan's sole security treaty ally and has the largest permanent overseas military presence in Japan, with around 55,000 troops stationed in the country.

All candidates have emphasized the need to strengthen the alliance with the United States, however, Biden has stated that he will block Nippon Steel's attempt to acquire an American steel company, leading to tensions in the bilateral relationship.

US officials claim that the deal poses security risks, a sentiment that Shigeru Ishiba has expressed dissatisfaction with. "What exactly are the security issues? We need them to tell us," he said during a campaign event earlier this month.

Nevertheless, Shigeru Ishiba may have to tread carefully on this issue as he holds 2,791 shares of Nippon Steel.

Nobuyasu Atago, Chief Economist at Rakuten Securities Economic Research Institute, stated, "Shigeru Ishiba's main challenge is likely to be in foreign policy, so we will have to wait and see how he performs in this area. I believe that, at present, there will not be any major shocks in economic policy." Despite facing a series of internal and external challenges, one of the main themes of this election in Japan is party reform. Previously, there were reports that a secret fund was set up by the Abe faction of the Liberal Democratic Party in Japan. The disintegration of the majority factions has led to the most competitive internal leadership struggle in decades.

Expectations of Rate Hike Rising

In addition, the new leader of the Liberal Democratic Party supports the efforts of the Bank of Japan to tighten monetary policy and emphasizes the development of regional economies with government spending to address the issue of declining populations in rural areas. Overall, he still supports the Bank of Japan's departure from ultra-low interest rates, while Takahiro Ishibashi believes that further rate hikes at this point would be "foolish."

In his election declaration, Fumio Kishida stated, "While respecting the independence of the Bank of Japan, I hope that through careful discussion, the authorities can normalize policies at a pace that is in line with the actual economic situation, without cooling down the economy."

Following the announcement of the election results, the yen surged significantly, with the USD/JPY exchange rate soaring to 142.89 at one point, Japanese bond futures falling, and Nikkei 225 index futures declining.

Previously, the market had been pricing in the possibility of Takahiro Ishibashi gaining the upper hand in the election. Earlier this week, comments from Takahiro Ishibashi supporting the Bank of Japan's maintaining loose monetary policy pushed the yen lower and supported the recovery of the Nikkei 225 index.

However, with Fumio Kishida's successful defeat of Takahiro Ishibashi, analysts suggest that the Bank of Japan is likely to continue raising interest rates.

Here are the views of analysts and strategists:

Shoki Omori, Chief Japan Desk Strategist at Mizuho Securities, said, "Many yen bears, especially speculators and hedge funds, have suffered losses. With Fumio Kishida becoming the next prime minister, all expectations for reflationary policies have disappeared. Clearly, many investors had expected loose policies to continue for a longer period, so there may be a repositioning of arbitrage trades or shorting of the yen, but all short positions are being closed. The Bank of Japan will continue to do its thing and focus on the data."

Alex Loo, Macro Strategist at Nomura Securities, said, "Based on Fumio Kishida's past remarks, he is seen as a 'hawkish' on monetary policy, hence the bullish sentiment on the yen. Today's result reinforces our belief that the Bank of Japan will raise rates again in December this year, and the compression of the US-Japan interest rate differential may push the USD/JPY back to the 140 level. We believe the risk lies in Fumio Kishida suddenly announcing early elections to ensure voter support, which would put the Bank of Japan in a wait-and-see mode this year."

Eugenia Victorino, Head of Asia Strategy at SEB, said, "With the uncertainty of the government's resistance to the normalization of Bank of Japan policy removed, the yen has strengthened once again. Overall, the Bank of Japan's policy is once again taking the lead. Today's political uncertainty is unlikely to have an impact on the market in the next 24 hours." French Agricultural Credit Bank's London-based strategist Valentin Marinov said: "The unexpected victory of neoliberalist Shigeru Matsu in the Liberal Democratic Party's leadership election may encourage a bullish yen, as this could intensify expectations that the Bank of Japan may implement further policy normalization as early as October."

"Moreover, any actions deviating from the fiscal radicalism of Abenomics could have significant implications for yen carry trades. Abenomics has been a hallmark of the Japanese economy over the past decade. In the long run, any wave of debt reduction and/or corporate restructuring could drive repatriation flows into the yen, thereby undermining yen funding carry trades," Marinov added.

Homin Lee, Senior Macro Strategist at Lombard Odier Singapore Ltd., stated: "Matsu's victory should be a moderate surprise to the market, as the momentum for Kishida seemed quite strong before the election. This may reflect that many in the ruling party believe that betting too boldly on the continuation of Abenomics, given the widespread unease caused by the weak yen in recent years, could backfire in the upcoming House of Representatives election."

Lee said: "We believe that the new cabinet under Matsu's leadership will broadly support the Bank of Japan's current gradual policy normalization plan, which will push the yen higher in the coming months. Our base case remains for the Bank of Japan to hike rates by another 25 basis points in December, with the USD/JPY falling further to 135 within 12 months."

Hiroshi Watanabe, Senior Economist at Sony Financial Group, stated: "The market briefly priced in 'Sanaenomics', but ultimately the USD/JPY fell, and the Japanese stock market seems to have lost all its gains today. There will not be significant changes in Japan's economic policy. The government will not excessively intervene with the Bank of Japan. The Bank of Japan will seek policy normalization while observing data, which will have some negative impact on the stock market. We believe that by the end of this year, the USD/JPY exchange rate will fall to around 139."

Charu Chanana, Global Market Strategist at Shengbao Bank, said: "This makes the yen once again a yield differential investment, and with Matsu's emphasis on national security, Japanese defense stocks may become a focus."

Hidetoshi Ohashi, Chief Credit Strategist at Mizuho Securities, said: "The market may experience volatility in the short term. Once the volatility subsides and everything returns to normal, the market will calm down. Matsu's policies do not differ significantly from Fumio Kishida's. If he emphasizes restoring fiscal discipline, a drop in the USD/JPY below 140, a strong yen will negatively impact Japanese companies' profits denominated in yen this year. This could lead to a decline in stock prices, low sentiment, and the Bank of Japan may find it difficult to hike rates. If the stock market falls and sentiment turns negative, credit spreads may also widen."

Andrew Jackson, strategist at Ortus Advisors Pte, said: "The market's reaction to Matsu's victory was intense, with the yen exchange rate soaring as clear evidence." Before the market closes, it is clear that the market is preparing for the victory of Takashi Higa. Therefore, it now appears that bank stocks will be favored again, while exporter stocks will be sold off."

Nana Otsuki, Senior Researcher at Pictet Asset Management Japan Ltd., said, "If the government is generous in spending, in the long run, the yen will weaken. Even if the government's monetary policy is neutral, expanding the budget for local development, other projects, and defense will raise long-term concerns about government finances, leading to a weakening yen."