Capital IdeasTM
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Japan
Anne Vandenabeele
- The BOJ’s resistance to tighter policy and higher JGB yields is understandable, but this is not a sustainable situation.
- Within equities, the impact of a weak yen varies from sector to sector.
- The BOJ is facing two bad choices: continue to allow the yen to weaken, sapping purchasing power; or, raise rates, likely leading to a drag on economic activity
The Japanese yen (JPY) has plunged to its lowest level in decades against the US dollar, as the Bank of Japan (BOJ) has kept its monetary policy ultra-loose even as other central banks begin to hike interest rates and dial back their asset purchase programmes.
The exchange rate, which currently sits around 135 yen to the dollar, is primarily driven by the difference between real interest rates in the United States and Japan. This means the yen is basically collateral damage from diverging central bank policies. I expect the yen to continue depreciating as long as the BOJ sticks with its yield curve control (YCC) programme and the Federal Reserve keeps driving US real rates higher. Could the yen fall as far as 150 against the dollar? Perhaps ― although that would be a worst-case scenario.
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Pressure mounts on the BOJ
As the yen slides, pressure is mounting on the BOJ. Investors have begun testing its commitment under the YCC to buy enough 10-year Japanese government bonds (JGBs) to pin their yield below 25 basis points. So far, the bank has not wavered, and the BOJ’s most recent meeting did not result in any policy changes. The BOJ’s resistance to tighter policy and higher JGB yields is understandable: domestic inflation in Japan remains significantly lower than many other developed markets. But this is not a sustainable situation as yen weakness is increasingly contributing to heightened imported inflation and falling real wages.
The BOJ is in a particularly tough spot because it likely does not want to look like it’s responding to the foreign exchange market. I expect there will be a change in policy at some point, but not until markets take a breather and the BOJ can control the narrative. Having a plan for rates and the credibility to impose it on markets is of paramount importance to the central bank.
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Diverging impacts of a weakening yen
Within equities, the impact of a weak yen varies from sector to sector. Large exporters such as automakers and semiconductor manufacturers typically benefit from a weak currency, although the effect may be blunted as much of Japan’s production base has moved overseas in recent years. Domestic and consumer-oriented companies are likely to lose out.
If the JPY/USD exchange rate spirals out of control, the first thing I expect is an intervention by Japan’s Ministry of Finance to buy yen. But that would likely be a short-term stopgap measure.
The BOJ’s policy options remain limited
Tweaks to BOJ policy could have a more lasting impact. The BOJ is effectively facing two bad choices: continue to allow the yen to weaken, sapping purchasing power; or, raise rates, likely leading to a drag on economic activity. If and when the BOJ acts, I believe it would probably first widen the band of yields it is willing to accept on 10-year JGBs under the YCC programme, allowing them to fluctuate between +/‒ 40 basis points, for example, rather than +/‒ 25 basis points. And if that’s not enough to stabilise the currency, the BOJ may consider shifting the YCC to target five-year bonds instead of 10-year bonds. Such a move could bring the yen closer to 120 against the dollar by sparking a small jump in 10-year yields and a wider spread between five- and 10-year JGBs. A final step could be to hike short-term rates slightly (possibly by 10 basis points) and officially end the country’s negative rates policy, the symbolism of which may help the yen regain some value.
That said, I believe the BOJ is unlikely to do much until it has flushed out all the investors betting against JGBs and it can provide an economic justification for tweaking policy. I should also emphasise that this would not be a fundamental pivot to a tightening cycle and policy normalization for the BOJ. Trend growth and inflation remain soft and do not justify much higher rates. So while the yen may appear extraordinarily cheap across many metrics, I do not expect it will start appreciating until we see a catalyst to break the current set of fundamentals that are keeping it cheap — lower real rates in the US or healthy reflation in Japan. Thus, I believe the yen is only attractive to investors who hold such long-term views and are willing to “fight the Fed and the BOJ” for quite some time.
1. Source: Factset. USD = USdollar. JPY = Japanese yen. As of 5 July 2022.
2. Source: FactSet Interest Rates, Tullett Prebon Information, *SWX Swiss Exchange. As of 5 July 2022
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