Japan’s stock market has been on fire over the past few years. The Nikkei 225, which tracks the 225 largest firms by market cap in Japan’s Tokyo Stock Exchange, has surged 130% from its COVID-induced low in March 2020 to a record high of over 38,000. That’s even better than the impressive 121% surge from the U.S.’s equivalent index, the S&P 500, over the same period.
Japanese stocks’ recent run is quite the shift from the pain of the previous three decades. The Nikkei 225 last hit a record 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. Now, though, just as Japan’s stock market is entering a new era of strength, its currency has collapsed.
The yen briefly touched a 34-year low compared to the U.S. dollar this week. And even after rising on Monday, perhaps due to an undisclosed intervention from the Bank of Japan, the dollar is now worth more than 157 Japanese yen, compared to just 129 in January of 2023. There are several reasons for the yen’s underperformance compared to the dollar, but the main one is clear: rising U.S. interest rates.
“The key lesson from Japan’s travails with the yen over the past couple years is that what matters most to the currency’s fortunes is expected interest rate differentials,” Jonas Goltermann, deputy chief market economist at Capital Economics, explained in a Monday note.
The phrase “expected interest rate differentials” may sound confusing, but it just means the anticipated difference between interest rates in Japan and other parts of the world, particularly the U.S.
When the U.S. or other western powers’ interest rates are higher than Japan’s, it puts pressure on the yen. Goltermann noted there are two main reasons for this phenomenon. First, because of Japan’s low interest rates, the yen is often used in the so-called “carry trade.” That’s when investors borrow 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. It’s slightly more complex than this in practice, as the fund manager in question would also need to swap rupees for dollars, and hedge his dollar risk, but that’s the general idea.
All of this means that when the interest-rate differentials between Japan and other major developed nations are high, traders will rush in to borrow yen for the carry trade, which weighs on the currency. And Bank of America’s analysts warned in a Friday note that the carry trade “is unlikely to start diminishing meaningfully until the Fed starts cutting rates, which our U.S. economists expect in December.”
The interest-rate differentials between western powers and Japan also impact investment and hedging in Japan’s $4.2 trillion portfolio of overseas assets. When Japanese investors see that interest rates are far higher in other developed nations, they’ll often increase their investment in these overseas assets, pulling down the yen. Hence, the rising interest-rate differential between the U.S. and Japan in particular has become problematic for the yen over the past few years.
The U.S. Federal Reserve has raised interest rates from near-zero in March 2022 to a range around 5.25% and 5.5% today in order to fight inflation. But the Bank of Japan has held interest rates in negative territory for eight straight years until last month, when officials raised rates to a paltry 0.1%.
Inflation rose to a peak of just 4.3% in Japan in January 2023, and for a nation that has battled deflation for so long, that wasn’t really a big concern for the Bank of Japan, so officials have been slow to raise rates. The Bank of Japan also indicated last week at a policy meeting that it would keep interest rates unchanged, despite the sizable interest rate differential with the U.S. and its declining currency. Although officials added they expect to gradually raise interest rates to 1%, investors balked at their dovish tone oerall, leading the yen to fall. “Markets seem to have reacted more to the lack of commitment to near-term hikes, rather than the promise of those in the distant future,” Bank of America analysts, led by Shusuke Yama, explained.
This dovish policy wasn’t so bad for the yen while many investors were forecasting a decline in U.S. interest rates this year. But with the U.S. economy proving its resilience to higher rates, and inflation showing signs of accelerating, most experts believe Fed Chair Jerome Powell and company aren’t likely to cut interest rates soon—and that means an even higher interest-rate differential between the U.S. and Japan than was previously forecast.
Capital Economics’ Goltermann explained the BoJ’s “very gradual” end to its negative interest rate regime essentially leaves them exposed to the monetary policy of other nations.
“Absent an unlikely change of heart at the BoJ, the yen will probably remain at the mercy of developments elsewhere, in particular the U.S.,” he wrote. “With the FOMC’s policy meeting on Wednesday alongside key US data points (the ISM survey and non-farm payrolls), this week may well prove a tricky one for the yen.”
Still, Goltermann said he expects the yen to rebound over time, noting the currency is now undervalued, and he believes the U.S. and European central banks will eventually cut their respective interest rates, lessening the painful interest-rate differential for Japan.
“Short-term noise in the data notwithstanding, we think the monetary policy cycle in the U.S. and Europe is turning towards easing,” he wrote. “Provided that forecast proves correct…our end-2024 USD/JPY forecast remains at 145.”
Bank of America analysts also said it may be a good time to “buy the dip” in the yen, arguing the Bank of Japan will hike rates in the third quarter, and the U.S. will cut rates, which will lessen the interest rate differential between the two powers, paving the way for yen appreciation.
