Policy expectations and market enthusiasm converge as Japanese bank stocks take center stage.

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The policy stance of Japan's new leader Sanae Takaichi is reshaping investors' expectations for the banking sector.

Although expectations for an accommodative monetary policy are weighing on bank stocks, analysts believe that demand for project financing driven by expansionary fiscal policy, as well as rapid yen depreciation which may force the central bank to raise interest rates, are factors likely to sustain the bull market in bank stocks.

In the "Takaichi trade" that drove Japanese stocks to record highs this week, bank stocks initially lagged. On Monday, while the Nikkei Index soared 4.75%, the TOPIX Banks Index fell 0.12%, as investors worried that accommodative monetary policy supported by Takaichi could delay the central bank's rate-hike plans.

The initial market focus was on Sanae Takaichi's support for fiscal stimulus and accommodative monetary policy. While this is a strong support for the stock market, it could also delay the Bank of Japan's plan to raise rates, thus reducing future sources of profits for banks, which is the core reason why bank stocks have come under pressure.

However, since the Bank of Japan ended its ultra-loose policy last March, bank stocks have risen by 47% in total, far outpacing the Nikkei's 21% gain over the same period. Makoto Kuroda, Goldman Sachs' Japan financial analyst, said that both regional and major banks would benefit from a broad expansion policy based on economic security.

Expansion Policy Drives Financing Demand

Sanae Takaichi has stated she will prioritize reviving regional economies in Japan, which may boost demand for local banks' expertise. Kuroda noted that both regional banks and large banks will benefit from a broad expansion policy based on economic security.

After years of negative interest rate policy, Japanese banks have developed business models that are not so reliant on domestic lending spreads. Mitsubishi UFJ Financial Group, Japan's largest bank by assets, estimates that rate hikes starting January 2025 will add an average of 166 billion yen in annual pre-tax profit over three years, but this is still less than one-tenth of its record 1.86 trillion yen in annual profit from the previous fiscal year.

"The impact of previous rate hikes hasn't been fully reflected in earnings, and there is still room to raise long-term guidance or the return-on-equity target," Kuroda said.

Central Bank Independence Limits Political Intervention

Although Takaichi's earlier comments opposing rate hikes have caused investor concern, analysts generally believe she has limited ability to pressure the Bank of Japan.

This is mainly because Japanese law guarantees the central bank's independence from government interference. Nicholas Smith, Japan strategist at CLSA, said Ueda still has 2.5 years left in his term and is legally protected, and Takaichi will not consider changing this law.

Yen Depreciation May Force the Central Bank to Hike Rates

It is noteworthy that the rapid weakening of the yen may force the central bank to take action.

Since the start of this week, the yen has fallen by about 3.5% against the dollar, dropping above 152 yen. SMBC Nikko analyst Masahiko Sato said, central bank decisions are heavily influenced by the exchange rate; if it falls to around 160 yen, raising rates to prevent currency depreciation will become possible.

Smith also warned that the Ministry of Finance holds enormous power and only a strong prime minister can make it yield. Whether Takaichi has this kind of leadership is still unclear, and it may be a mistake to overestimate the government's ability to sharply increase spending.

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