Yen Faces 5% Decline as Political Risks Fuel Depreciation

In anticipation of the Bank of Japan's policy decision, option traders are positioning themselves for further depreciation of the Japanese yen. Over the past three months, the yen has lagged behind all other major currencies, and with increasing political risks in Japan, the currency is facing additional downward pressures. Strategists are bearish on the yen, expecting that the recent parliamentary election results will increase government spending, while the impact of U.S. tariffs may slow the Bank of Japan's tightening pace. This sentiment is in line with the views of option traders who are preparing for the yen to resume its downward trend.

The ruling Liberal Democratic Party's loss in the July 20 election has become a significant factor for the yen. Analysts warn that to strengthen its weakened governing coalition, the Prime Minister may resort to populist spending. A $55 trillion fund, part of a trade agreement, allocated for investment in the U.S. could also stimulate capital outflows and exert long-term pressure on the yen.

"Although the election is over, there are still political risks, such as the possibility of the Prime Minister stepping down and triggering a September leadership election for the Liberal Democratic Party," said the global market research head. "Given the short-term growth and inflation risks are biased downward, the demand for dollar/yen call options may also reflect market expectations that Bank of Japan Governor will not quickly signal a rate hike."

Data from the Depository Trust & Clearing Corporation on July 28 showed that dollar/yen call option trading indicated that the number of bets on the dollar rising against the yen was nearly four times that of bets on it falling. This pessimistic outlook contrasts with asset management companies, which data showed had increased their net long positions in the yen as of the week ending July 22. Similarly, leveraged funds reduced their short positions in the yen during this period.

Since hitting a seven-month high in April, the yen has depreciated by more than 5% against the dollar to 147.91, partly due to concerns over Japan's election. Market participants betting on yen depreciation expect the Prime Minister to yield to opposition calls for costly tax cuts to boost support for the governing coalition. Some analysts suggest that if the Prime Minister steps down, could take over, who is a strong advocate for fiscal and monetary stimulus and narrowly lost to the Prime Minister in last year's Liberal Democratic Party leadership race.

"Regardless of the final political outcome, fiscal policy may take a more expansionary path," wrote strategy analysts. "Given the recent sensitivity of dollar/yen to changes in long-term premiums, if an expansionary fiscal policy is pursued, dollar/yen could rise above 150."

Further depreciation of the yen could revive popular carry trade strategies, which involve borrowing the relatively low-yielding yen and investing in higher-yielding currencies. A senior foreign exchange options trader in London noted, "We see several reasons for the dollar's rise against the yen—bets against the dollar seem overdone, while going long on dollar/yen offers good carry in the quiet summer."