Japan’s stock market has been on a roll over the past few years. The Nikkei 225, which tracks the 225 largest companies in terms of market capitalization on the Tokyo Stock Exchange, Japan, has risen 130% since the Covid-induced low in March 2020, reaching a record high of more than 38,000 points. This result even surpasses the impressive 121% growth of the equivalent US index, the S&P 500, in the same period.
The recent appreciation of Japanese stocks marks a significant change from the difficulties faced in the previous three decades. O Nikkei 225 It last hit an all-time high during a market bubble in 1989, before three “lost decades” of low economic growth and stagnant prices in Japan led to years of underperformance. Yet now, just as Japan’s stock market is entering a new era of strength, its currency has collapsed.
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This week, the yen briefly hit a 34-year low against the US dollar. And even after rising on Monday, perhaps due to an undisclosed intervention by the Bank of Japan, the dollar is now worth more than 157 Japanese yen, up from just 129 in January 2023. There are several reasons for the yen’s weak performance in relation to the dollar, but the main one is clear: the increase in interest rates in the USA.
“The main learning from Japan’s struggles with the yen over the past two years is that what matters most for the currency’s future are expected interest rate differentials,” explained Jonas Goltermann, deputy chief market economist at Capital Economics , in note.
The phrase “expected interest rate differentials” may seem confusing, but it just means the expected difference between interest rates in Japan and other parts of the world, particularly the US.
When interest rates in the US or other Western powers are higher than those in Japan, this puts pressure on the yen. According to Goltermann, two main reasons explain this phenomenon. First, due to Japan’s low interest rates, the yen is often used in the so-called “carry trade”. This occurs when investors take out loans at a low interest rate to invest in an asset with a higher return.
For example, a fund manager might borrow yen and then invest that money in Indian bonds that offer a higher yield, pocketing the difference. In practice, it’s a little more complex than this, since the fund manager in question would also need to exchange rupees for dollars and cover their risk in dollars, but that’s the general idea.
This all means that when interest rate differentials between Japan and other major developed nations are high, traders will rush to borrow yen to carry trade, which weighs on the currency. And, on Friday, Bank of America analysts warned in a note that “it is unlikely that the carry trade will begin to decline significantly until the Fed begins to cut rates, something our North American economists hope will take place in December”.
Interest rate differentials between Western powers and Japan also impact investment and coverage of Japan’s $4.2 trillion foreign asset portfolio. When Japanese investors notice that interest rates are much higher in other developed countries, they often increase their investments in these foreign assets, pulling the yen down. Thus, the growing differential between US and Japanese interest rates in particular has become problematic for the yen in recent years.
In order to combat inflation, the US Federal Reserve raised interest rates from near zero in March 2022 to the current range of 5.25% to 5.5%. But the Bank of Japan kept interest rates in negative territory for eight consecutive years until last month, when authorities raised them to a paltry 0.1%.
Inflation peaked at just 4.3% in Japan in January 2023, and for a nation that has fought deflation for so long, that wasn’t really a big concern for the Bank of Japan, so authorities have been taking their time. to increase rates. The Bank of Japan also indicated last week at a policy meeting that it would keep interest rates unchanged despite the considerable spread between U.S. interest rates and its declining currency.
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Although officials have said they hope to gradually raise interest rates to 1%, investors balked at their dovish tone, which pushed the yen lower. “Markets appear to have reacted more to the lack of commitment to short-term increases than to the promise that this would occur in the distant future,” explained Bank of America analysts, led by Shusuke Yama.
This peaceful policy did not have such bad effects for the yen while many investors predicted a fall in US interest rates this year. But with the US economy proving its resilience to higher rates and inflation showing signs of accelerating, most experts believe that Fed Chairman Jerome Powell and company are unlikely to cut interest rates anytime soon, which means an even higher interest rate differential between the US and Japan than previously anticipated.
Goltermann of Capital Economics explained that the Bank of Japan’s “very gradual” termination of its negative interest rate regime essentially leaves it exposed to the monetary policy of other nations.
“In the absence of an unlikely change of heart by the Bank of Japan, the yen will likely remain at the mercy of developments elsewhere, particularly in the US,” he noted. “With the FOMC policy meeting on Wednesday, along with key US data (the ISM survey and non-farm payrolls), this week could be tricky for the yen.”
Still, Goltermann said he expects the yen to recover over time, noting that the currency is currently undervalued, and believes that U.S. and European central banks will eventually reduce their respective interest rates, narrowing the painful rate differential. interest rates for Japan.
“Despite the short-term noise in the data, we believe that the monetary policy cycle in the US and Europe is becoming more flexible,” he analyzed. “As long as the forecast is correct… our USD/JPY forecast for the end of 2024 remains at 145.”
Bank of America analysts also said it could be a good time to “buy the dip” in the yen, arguing that the Bank of Japan will raise rates in the third quarter and the US will cut them, which will narrow the interest rate differential. between the two powers, paving the way for the appreciation of the yen.
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