By Junko Fujita and Kevin Buckland
TOKYO (Reuters) -Heading into the most consequential Japanese upper house election in memory and a possible defeat for the coalition of Prime Minister Shigeru Ishiba, investors are weighing whether a record sell-off in the nation's debt has further to run.
Japanese government bonds (JGBs) plunged this week, sending yields on 30-year debt to an all-time high, while the yen slid to multi-month lows against the U.S. dollar and the euro.
Polls have only gotten worse for Ishiba's ruling Liberal Democratic Party and junior coalition partner Komeito in the final run-up to Sunday's vote, where upstart parties campaigning on increased spending and tax cuts are likely to gain seats.
These are the main scenarios investors and analysts are considering:
The LDP coalition retains its majority
Analysts generally say the most bullish case for the JGB market and the yen is if the government can hold on to a majority.
The government's overall debt burden, while still the highest in the developed world at about 250% of gross domestic product, is on a declining trend.
“It is difficult to conclude that Japan's fiscal condition is on a path of continuous deterioration,” said Koichi Fujishiro, an economist at the Dai-ichi Life Research Institute. “Once the upper house election is over, upward pressure on interest rates stemming from expectations of increased fiscal spending may begin to ease.”
A victory for Ishiba's coalition would likely see a recovery for the JGB market, where an eight-day sell-off sent yields on 30-year debt up 35 basis points (bps) to a record 3.20% on Tuesday.
“If this scenario plays out, some of the JGB shorts look vulnerable, as Ishiba is expected to resist talk of debt-financed tax cuts,” Standard Chartered analysts said in a note.
LDP coalition is weakened, and Ishiba steps aside
An increasingly likely outcome is that Ishiba's coalition fails to win the 50 seats needed to retain its upper house majority, forcing it to seek additional partnerships.
Among the most likely candidates is the Democratic Party for the People (DPP), which has urged the Bank of Japan to reverse course and again loosen monetary policy.
The surge in JGB yields this week was the market pricing in such a scenario, said Takashi Fujiwara, chief fund manager at Resona Asset Management's fixed income investment division.
Within the LDP, a leading candidate to replace Ishiba, should he be forced to step down, is Abenomics proponent Sanae Takaichi, who has advocated for a resumption of monetary easing by the BOJ.
