Japanese shares are expected to continue setting new records after fiscal dove Sanae Takaichi won the leadership of the ruling Liberal Democratic Party (LDP) this Saturday and positioned herself to become Japan’s next prime minister, but the yen and government bonds remain under pressure.

Takaichi, 64, was one of five candidates vying to succeed hawkish Prime Minister Shigeru Ishiba and was the most expansionary-minded among them, promising Abenomics-style fiscal and monetary stimulus policies – many of which were initiated by the late Shinzo Abe.

In the weeks preceding the LDP leadership vote, a so-called “Takaichi trade” emerged, with investors going long on Japanese equities and shorting government bonds, particularly those with longer maturities.

The move reflected rising optimism that a Takaichi victory would bring in a period of sustained fiscal growth and central bank cooperation, similar to the Abe-era policy combination that boosted asset prices while weakening the yen.

According to Reuters, investors are bracing for a dovish turn even before the election results, with market participants anticipating that any successor to Ishiba will prefer stimulus over restriction.

Nikkei surges to a record as short covering builds

Japan’s benchmark Nikkei, the Nikkei stock index (N225), set another record close of 45,769.50 on Friday, beating last week’s peak, buoyed by buying on the backdrop of political transition.

Bears have been piling on short positions on the index in recent sessions, but strategists expect a short-covering frenzy if new leadership wins.

That would be a “positive surprise to stock prices,” according to Hiroki Takei, a strategist at Resona Holdings. “The rally could gain momentum in case of short covering led by resistance near 47,000,”

The rally reflects the belief that Japan’s economy is steering the management toward a more loose fiscal and monetary settings, which will provide support for equity gains while the fixed-income market prepares for a fresh round of tumult.

According to Reuters, foreign investors, who have been net buyers of Japanese shares over the year, are also expected to keep money flowing into the market by betting on continuous corporate earnings growth and government expenditure.

Bonds under strain amid waning support

With stocks hitting up, the Japanese government bond (JGB) market is still fragile. The sector came under pressure starting in May when demand from traditional investors dried up, support from the Bank of Japan (BOJ) faded, and fears of growing fiscal deficits started to emerge.

Following Ishiba’s declaration that he would resign, the 30-year JGB yield soared to a staggering 3.285% on September 8, and has since lingered around those highs.

They also expect, for now, a growing resistance to higher policy rates, although investors are more wary that any of Takaichi’s policies may weigh down on already heavy government debt.

The fiscal outlook worsened as Ishiba’s coalition lost its majority in both houses of parliament, creating opportunities for opposition parties to propose tax cuts and higher spending, two measures that risk reinforcing fiscal slippage.

Yen faces conflicting pressures

The Japanese currency finished Friday at 147.44 per dollar, marking its biggest weekly rally since mid-May.

But analysts see renewed weakness in the dollar if investors sense that Takaichi’s administration will either slow the pace of further rate hikes or try to exert pressure on the BOJ’s course of tightening.

Takaichi, after winning her LDP post, said the government and Bank of Japan must “coordinate closely” to create inflation supported by wage increases and corporate profits.

Japan is already in the process of years of long-awaited normalisation under BOJ Governor Kazuo Ueda, incrementally tightening interest rates and reducing the central bank balance sheet after a chronically ultra-loose policy stretching decades.

The yield on two-, five- and 10-year JGBs is now at its highest level since 2008 on increased bets the BOJ could raise rates again as soon as this month.

Policy outlook: dovish pressure ahead

Takaichi’s strong support among rank-and-file LDP members is expected to give her government a major advantage in setting BOJ policies.

“Takaichi will make it difficult for the BOJ to raise interest rates, so yields will fall,” said Tohru Sasaki, chief strategist at Fukuoka Financial Group and former BOJ official.

At the same time, she is expected to increase expenditure, which is negative for bonds. A steepening of the yield curve is one conceivable outcome.

In markets that have already been conditioned by a decade of stimulus, investors appear to be ready for another round, one in which equities soar, bonds stumble, and the yen battles to find a footing.

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