Japan’s central bank raised interest rates last week for the first time in seventeen years, ending the world’s only remaining negative interest rate regime. The Bank of Japan also abandoned its yield curve control policy which has been in place since 2016, which saw it buying Japanese government bonds to keep longer term interest rates from rising. It has however maintained bond buying at the same pace for now.
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Japan’s central bank raised interest rates last week for the first time in seventeen years, ending the world’s only remaining negative interest rate regime. The Bank of Japan also abandoned its yield curve control policy which has been in place since 2016, which saw it buying Japanese government bonds to keep longer term interest rates from rising. It has however maintained bond buying at the same pace for now.
Patrick's Books:
Statistics For The Trading Floor: https://amzn.to/3eerLA0
Derivatives For The Trading Floor: https://amzn.to/3cjsyPF
Corporate Finance: https://amzn.to/3fn3rvC
Patreon Page: https://www.patreon.com/PatrickBoyleOnFinance
Buy Me a Coffee: https://buymeacoffee.com/patrickboyle
Visit our website: www.onfinance.org
Follow Patrick on Twitter Here: https://twitter.com/PatrickEBoyle
Patrick Boyle on YouTube
Japan’s central bank raised interest rates last week for the first time in seventeen years, ending the world’s only remaining negative interest rate regime. The Bank of Japan also abandoned its yield curve control policy which has been in place since 2016, which saw it buying Japanese government bonds to keep longer term interest rates from rising. It has however maintained bond buying at the same pace for now.
If Japanese rates were to continue to rise, it could have global repercussions as the Yen’s stability and low interest rates have given it a role in international finance that might be about to change.
Negative interest rates are when central banks require their counterparties to pay to store their excess cash at the institution. Following a 7-2 vote last week, it was announced that the central bank would guide Japan’s overnight interest rate to a range of about zero to 0.1 per cent.
Obviously, this is not a huge rate hike, the prior benchmark rate had been minus 0.1 per cent. It is maybe more important symbolically than anything else.
Japan has a long history of central banking innovations – or unconventional monetary policies - which were introduced after the Japanese asset price bubble burst in the 1990’s. While Japan was not the first country to introduce negative interest rates (that honor goes to Sweden) it was the first country to introduce zero interest rates in 1999.
The bank of Japan also pioneered asset purchase programs – known as quantitative easing along with the yield curve control policy, both of which became widely used by central banks around the world in the wake of the global financial crisis.
The Bank of Japan went a bit further than other central banks buying up stock market funds and real estate linked securities in what it referred to as qualitative easing.
The negative interest policy which has just ended involved applying different interest rates to different tiers of bank reserves in order to prevent the banks from hoarding cash.
Achieving the 2% inflation target is finally getting within reach in Japan due to recent wage inflation. Japan’s largest federation of trade unions recently negotiated a weighted average 3.7% increase in base pay. This was stronger than last year’s wage gains, which were the steepest in thirty years.
The Bank of Japan has said that they expect higher incomes to lead to a virtuous spiral with domestic demand fueling inflation. They say that their long-held goal of stable 2% inflation is finally “within sight”.
There were no shock waves associated with the announcement as the decision was widely expected and well telegraphed. “Core-core inflation - which excludes fresh food and energy prices - and is closely watched by the BOJ as a better gauge of trend inflation has been above the 2% target for more than a year, but policymakers took it easy believing that some of this inflation was largely imported from overseas.
The low-return environment in Japan has pushed Japanese investors into being amongst the biggest capital exporters in the world: they own over a trillion dollars of US Treasuries and half a trillion Euro bonds. Now that domestic yields in Japan might be on the rise, will they stop investing as much abroad?
Japanese banks and institutions have over the years become big foreign investors. Decades of ultra-low interest rates encouraged yield-seeking Japanese investors to keep their savings overseas, particularly in foreign bonds. Commerzbank estimates that Japanese investors own more than $2tn in foreign bonds and international investments are estimated to be around four trillion dollars in total.
Low interest rates combined with the yen’s stability made it the currency of choice for carry trades, where an investor borrows in Yen to fund investments in other countries where interest rates and expected returns are much higher.
This style of investment can (of course) be quite risky. Big currency moves can wipe out returns and force investors to unwind their trades. For this reason, the Yen usually rallies during times of market stress, as investors exit these trades and repatriate their money to Japan.
Japan is the largest foreign holder of US government debt and in a world of higher Japanese interest rates money that has been invested abroad could be brought back to Japan, impacting the demand for US treasuries and Euro denominated bonds.
US bonds have already become less attractive to Japanese investors, as when they buy Treasuries, they usually don’t want to run the foreign exchange risk and thus hedge it out.
After hedging US Treasuries are the most expensive, they’ve been in decades for Japanese investors, and for this reason this trade has been unwinding over the last two years.
John Authers at Bloomberg points out that since the beginning of 2020, a carry trade of borrowing in yen and investing in the Mexican peso, where rates are above 11% has made a far bigger profit than an investment in the S&P 500.
Samurai bonds are yen denominated bonds issued by foreign entities in Japan, allowing non-Japanese governments and corporations to secure capital from Japanese investors – often at lower rates than they would get in their home markets.
In recent years, highly indebted African countries like Kenya, Egypt and Rwanda have issued Samurai bonds. This debt has mostly been issued at fixed interest rates which means that the change in interest rate should not affect the borrowers, but if the yen were to appreciate against their currencies, it would be more expensive to pay back these loans. For these reasons, developments in Japan matter for global markets.
Japan’s debt reached $8.6 trillion dollars at the end of last year. At 255 percent of GDP that is more than twice the debt to GDP ratio of the United States and is the highest in the developed world. The future pace of rate increases will depend on a number of factors such as whether businesses and households can handle higher borrowing costs than they have become accustomed to.
Servicing Japan’s massive government debt is already a struggle which will become more difficult once negative interest rates and yield-curve control have been abandoned.
For Japanese banks, higher interest rates can be expected to boost net interest margins, and the FT points out that Japanese banks have performed very well over the last year in expectation of this interest rate hike with shares in Mitsubishi UFJ Financial Group up more than 80 per cent in the last year.
Large Japanese companies have 49 per cent cash on their balance sheets as a proportion of net assets, according to the same article and higher interest rates would help these companies too.
Should rates continue higher, investors in Japanese bonds could face losses not unlike what we saw when US rates rose rapidly last year. According to the Wall Street Journal, Japan’s Financial Services Agency warned regional banks in mid-July that they should be ready to respond flexibly to rapid interest-rate fluctuations. Very few Japanese bankers have any experience in a rising interest rate environment.
Japan’s share of global GDP in Purchasing Price Parity terms fell from 9% in 1990 to under 4% today and while deflation slowly made Japan relatively poorer, it actually worked out well for certain salaried workers who made a steady income while prices fell around 1 percent per year. In the new inflationary environment wages have been rising slower than retail prices, frustrating these Japanese workers.
The past 30 years have seen many false dawns in Japan. The Economist points out that while price inflation is still above 2%, it is already falling. They argue that for the trend to continue, Japan needs reforms that raise productivity and boost the potential growth rate, otherwise deflation could return.
Japan is faced with some big structural problems – an ageing population, low growth and high public debt. While all developed countries are aging, none are doing so as fast as Japan.
Around the turn of the century the phrase Japan’s 2025 problem was coined. It referred to how by 2025, all six and a half million of Japan’s baby boom generation would be 75 or older. Japan in 2025 would become a super-aged society the likes of which has not been seen before. Based on current projections, by 2050 there will be almost the same number of workers in Japan as retirees.
The elderly in Japan vote for, and get old-age benefits, and many young Japanese people don’t vote - aware that their numbers are not sufficient to counterweight the votes of the elderly population. In a country with high debt the high number of elderly people can be expected to put extreme strain on the economy, welfare programs and retirement plans
My friend Manoj at Talking Heads Macro argues that the Bank of Japan’s optimism that wage negotiations would deliver stronger nominal (and real) wage growth leading to consumption growth might be wrong. He argues that Japan’s real wages have fallen over the last two years and that consumption growth will only come after households have recouped the purchasing power they lost due to inflation.
He says that households will need several quarters of wages outstripping prices before the wage level catches up with the price level. Only then will they feel that their wages can be used for broad-based consumption… that time is not now.
For the time being, a sharp increase in Japanese interest rates seems unlikely. Japanese policymakers have been careful to signal they are not embarking on a tightening cycle and that the central bank is prepared to intervene to support financial stability if needed.
Wages are still quite weak in Japan and further wage growth would be needed for inflation to remain on target. The BOJ referred to extremely high uncertainty in their outlook meaning that they just don’t know if they are on track with inflation or not. A lot will depend on what happens if the US federal reserve starts cutting rates as the difference between Japanese interest rates and US interest rates is quite wide at present. If the Fed started cutting rates, narrowing that gap, the yen could start to rise as Japanese rates become relatively more attractive. This would make imports cheaper, putting downward pressure on prices.
All of Japan’s big structural challenges remain the same, and to quote Robin Harding from The FT “it is not clear if there is any stable equilibrium where Japan chugs along with consistently positive interest rates and inflation at its 2 per cent target. The Bank of Japan has signed an armistice with unconventional monetary policy, not a peace treaty”.
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