Investors Ready for Bumpy Ride Aboard the "Abe Trade"

Shinzo Abe, incoming Prime Minister of Japan.
Yoshikazu Tsuno | AFP | Getty Images
Shinzo Abe, incoming Prime Minister of Japan.

Printing money and going on a spending spree would usually sow alarm in a heavily indebted economy, but investors in Japan are betting that opposition leader Shinzo Abe will tone down his strategy if he wins power in Sunday's national election.

Made a firm favorite by opinion polls to become the next prime minister, the Liberal Democratic Party (LDP) leader wants to step up aggressive monetary easing along with heavy public works spending to help Japan escape years of deflation and make the yen more competitive so that a spluttering economy can start motoring again.

His policy prescriptions, dubbed "Abenomics" by the media, and his threat to curtail the Bank of Japan's independence, have sent a chill through some quarters of the central bank.

But investors see some merits in the strategy, and reckon the responsibility of power will prevent Abe taking excessive risks that could lead to a bond market meltdown.

"Japan could be the only industrialised country to be able to pursue a reflationary policy mix of monetary accommodation and fiscal expansion," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.

That prospect has led to a wave of yen selling that currency dealers are calling the "Abe trade". The yen, currently trading around 82.85 to the dollar, has fallen some 4 percent since the election's announcement in mid-November, bringing some relief for Japan's suffering exporters.

Over the same period, the Nikkei's benchmark index has gained 10 percent.

Meanwhile, the benchmark 10-year Japanese government bond yield hit a 9-1/2-year low of 0.685 percent last week after holding steady around 0.7 percent for months.

Sense of Perspective

The combination of a weaker yen, rising stock prices and low bond yields could help lift Japan out of its fourth recession since 2000, analysts and economists say.

The persistently strong yen has wiped out manufacturing competitiveness and spurred companies to relocate overseas, chipping away jobs and further aggravating the low-grade deflation that has dogged Japan's economy for two decades.

The low-and-steady yields in the Japanese government bond (JGB) market represent a consensus that Abe can steer the central bank toward a sharp increase in its bond purchasing without triggering runaway inflation or a financial panic.

And there is growing acceptance both in markets and inside the BOJ that the aggressive easing Abe talks about will not amount to a "big bang" in central bank policy.

But Abe's honeymoon with the markets could end badly if investors became alarmed over any danger that the government could lose control of a debt burden that already amounts to nearly 237 percent of GDP.

"The risk to the JGB market," said Katsuyuki Tokushima, chief pension adviser at NLI Research Institute, "is that the government gives up on fiscal consolidation, gives up on the (consumption) tax hike, spends trillions of yen on public works, and the BOJ's independence in deciding monetary policy measures is ignored, and it prints money limitlessly."

(Read More: Economic Woes Turn US, Japan Into Ugly Stepsisters)

It would be a doomsday scenario for Japan's markets if scared investors began unloading their heavy holdings of yen bonds, with alarm spreading to the share market as rising yields would erode corporate profits.

Avoiding Pitfalls

The current central bank governor, Masaaki Shirakawa, has aired skepticism over Abe's proposals, but his term is up in April and if Abe becomes prime minister he will have a big say over who replaces Shirakawa.

Analysts reckon Abe would be ill-advised to take away the central bank's independence, as investors could become anxious if there were no check on a politician who wants the BOJ to pursue "unlimited" easing to drive a stake through deflation.

"The Japanese public don't trust politicians, but they trust the BOJ. If that confidence is challenged, there is no guarantee that Japanese will hold onto their yen assets," said Daisuke Karakama, market economist for Mizuho Corporate Bank in Tokyo.

More than 90 percent of Japan's roughly $12 trillion in debt is held by domestic investors. By contrast, half of euro zone bonds and more than half of U.S. Treasuries are in the hands of foreign investors.

Analysts say Abe should also shore up confidence by delivering on a proposed hike in the consumption tax from 5 percent to 8 percent, a crucial step needed to avoid a credit rating downgrade.

More immediately, some analysts expect the central bank to expand its balance sheet by buying bonds with longer maturities, a step that would flatten out the yield curve and make the 10-year bond more responsive to the BOJ's easing.

The bank may also purchase riskier assets, a step that could improve business sentiment and lift equities.

(Read More: What Will Save the Japanese Economy?)

Post-Election Markets

A big win for Abe on Sunday could see the Nikkei lose some of the gains made in the run-up to the vote as investors take profits. The yen could also make a short-lived recovery, but its weaker trend looks set to stay, analysts and traders say.

The net yen short position in the futures market hit its highest level since mid-2007, suggesting it is ripe for a profit-taking rally.

But analysts say any recovery would run out of steam at around 80 to 81 yen to the dollar. That's in part because the yen's appeal as a safe-haven has also weakened, not least because of Japan's deteriorating balance of payments position. Traders expect the yen to trade between 80 to 85 against the dollar for the next several months.

The Nikkei's performance could be largely determined by the currency movements. Hovering around 9,500 points, the index is nearing the 10,000-plus levels seen in April, before a slide to 8,200 in early June. The recent rise has been largely attributed to short covering and reallocation by investors who had underweighted the Nikkei.

Some 70 percent of trading in Nikkei is done by foreign investors, who analysts say take their immediate cues from the strength or weakness of the yen.

"Foreign investors are buying mainly because of the yen weakness so when the yen weakness stops, they will take some profits," said Naohiko Baba, Japan chief economist at Goldman Sachs.