Don't be misled by Shipo Mao, the market may be underestimating the probability of Japan raising interest rates

Barclays believes that the market is underestimating the probability of the Bank of Japan raising interest rates due to Prime Minister Fumio Kishida's dovish remarks and the relatively strong performance of the Japanese economy.

On Friday, October 11th, Shinichiro Kadota, an analyst at Barclays Bank's Japan Foreign Exchange and Interest Rate Research Department, and his team released a report stating that the results of the Japanese House of Representatives election held in late October will impact the Bank of Japan's interest rate decision:

"If the Liberal Democratic Party-Komeito coalition wins a majority of seats in the election, Fumio Kishida's dovish remarks may decrease, and the market's expectations for the Bank of Japan to raise interest rates will strengthen."

"However, if the Liberal Democratic Party-Komeito coalition loses the majority of seats, Fumio Kishida's dovish remarks may continue until the Upper House election in July 2025, further suppressing the market's pricing of the Bank of Japan's interest rate hike."

Furthermore, the Bank of Japan's assessment of the overall performance of the Japanese economy, combined with cautious remarks from Haruhiko Kuroda, has weakened the market's expectations for the Bank of Japan to raise interest rates.

Barclays expects the speed and magnitude of the Bank of Japan's interest rate hike to exceed the current overnight index swap (OIS) pricing. The Bank of Japan is expected to raise interest rates by 25 basis points in December of this year or January of next year, and then raise rates by another 25 basis points in July to bring the rate to 0.75%.

In early August, market expectations for the Bank of Japan to raise interest rates plummeted significantly due to market turmoil, a weakening yen, and the approaching Liberal Democratic Party election. However, despite Fumio Kishida, who has always taken a hawkish stance during elections, winning, and the Bank of Japan's assessment indicating that the Japanese economy is recovering, the pricing of overnight index swaps for the Bank of Japan's interest rate hike has still not returned to the level seen after the July rate hike.

Results of the Japanese House of Representatives election will impact the Bank of Japan's interest rate decision

Before the Liberal Democratic Party election, Fumio Kishida was seen as a representative of the hawkish stance on interest rate policy due to his support for rate hikes. However, the day after Kishida was elected as Prime Minister, he made dovish remarks stating, "I do not think we are in an environment that requires further rate hikes."

On October 27th, Japan will hold a House of Representatives election. Barclays stated that Kishida's moderate remarks reflect his low approval ratings. According to a report by the Nikkei on October 2nd, Kishida's approval rating is only 51%, one of the lowest among newly appointed Prime Ministers in modern Japanese history.

Barclays believes that "If the Liberal Democratic Party-Komeito coalition wins a majority of seats in the election, Fumio Kishida's dovish remarks may decrease, and the market's expectations for the Bank of Japan to raise interest rates will strengthen. However, if the Liberal Democratic Party-Komeito coalition loses the majority of seats, Fumio Kishida's dovish remarks may continue until the Upper House election in July 2025, further suppressing the market's pricing of the Bank of Japan's interest rate hike."

In the unlikely event that the Constitutional Democratic Party of Japan takes over the government, the party's policy proposal is to lower the inflation target to "above 0%", which could lead to a significant interest rate hike by the Bank of Japan and a strengthening yen

Japan's Strong Economic Conditions Dampen Expectations of BOJ Rate Hike

According to the Bank of Japan's economic assessment, the overall performance of the Japanese economy is good. In its September meeting statement, the Bank of Japan raised its expectations for private consumption, aligning with expectations of a bottoming out of GDP growth in the first quarter of 2024. Furthermore, core inflation driven by import prices is extending to the service sector, reflecting the strong results of Japan's spring labor negotiations (Shunto) now evident in monthly wage data.

However, BOJ Governor Haruhiko Kuroda maintained a cautious tone at the post-meeting press conference, emphasizing the need to confirm progress in service sector inflation and wage growth. He also added that the soft landing of the U.S. economy and the correction of the weakening yen have bought the Bank of Japan some time. Kuroda's remarks have dampened market expectations of a BOJ rate hike