Japan’s exit from negative rates: Implications for the economy, yen and stocks
By Charu Chanana, Head of FX Strategy at Saxo
Historic decision from the Bank of Japan to exit negative interest rates signals confidence in Japan's economic recovery. Given that the BOJ tightening cycle is unlikely to be aggressive, the Japanese yen could remain under pressure until the Fed changes course. Meanwhile, Japanese equities could withstand higher rates for now, but Q2 could bring risks if US economic momentum weakens and the Fed’s dovish tilt strengthens the yen. As such, a more bottom-up approach to Japanese equities may be considered, focusing on fundamentals and structural tailwinds.
The Bank of Japan has entered a new era as it scrapped negative interest rates and yield curve control. The central bank has set the short-term interest rate at between 0-0.1% in its first rate hike since 2007. While well-anticipated, the BOJ’s end of negative interest rate policy could have a plethora of implications for domestic and global markets.
The orthodox policy has been kept in place as authorities wanted to encourage bank lending, spur demand and nurture inflation. Now, with inflation hovering over the 2% target for 22 months straight, and signals of wage growth gathering pace, this new era is also a signal of Japan’s new economic landscape.
Where does the BOJ go from here?
While we can say that the BOJ ended the era of negative rates, it remains hard to say how far the central bank will go on the positive rate territory. Despite an end to YCC, the BOJ said that they are still maintaining JGB purchases and will step in where necessary if yields run too high, too fast.
There was also no forward guidance about future policy steps and the pace of normalisation. Even though the normalization move came in earlier than we expected, the pace of normalization seems to be what we had expected. Our earlier note on “A reality check on Bank of Japan’s policy normalization and JPY appreciation expectations” argued that the BOJ will need to consider debt sustainability risks and the lack of a JGB market and will likely stick with modest and gradual normalization policy. We continue to expect policy to remain accommodative and financial conditions to remain loose in Japan until there is further evidence of sustainable inflation.
What are the implications of the BOJ exit for Japanese economy?
Usually, the early part of a tightening cycle is indicative of economic strength, and its only when the tightening goes a bit further that economic weakness starts to be a concern. Likewise, BOJ’s modest tightening is a sign that the Japanese economy may be at a turning point and the central bank is more confident that the economy can withstand higher rates.
This is a wide shift away from the downward spiral that the Japan economy has been locked in seen for decades – one of weak consumption, no price hikes, dwindling company profits and lack of investments and wage growth.
With wage growth of the order of 5% as evident from the early Rengo wage negotiation results, there is reason to believe that we could see income effect helping to stimulate consumption. Additionally, an increase in asset values, such as stocks and real estate, due to a positive market response to higher interest rates, could also contribute to higher consumer spending through wealth effects.
Higher consumption gives companies the flexibility to raise prices, boost margins, and increase capital spending, resulting in a virtuous cycle of increased wage gains and inflation.
The path forward for Yen and carry trades
We had argued before the BOJ decision that a hike will be accompanied by dovish commentary, and it is no surprise to see the reaction of the Japanese yen that has weakened despite the rate hike from BOJ. The only thing that can sustainably reverse the yen weakness is a dovish Fed, not a hawkish BOJ.
Remember that USDJPY is a yield differential play. With Fed rates at 5.50%, a BOJ hike from -0.1% to 0-0.1% doesn’t close the yield gap in any significant way. Even considering the forward pricing for BOJ, only about 40bps of additional tightening is priced in for the next two years. That is very modest. The Fed needs to be bulk of the work in closing the yield gap between Treasuries and Japanese government bonds, and so the fate of the yen remains in the hands of Chair Powell, rather than Governor Ueda.
With the BOJ tightening behind us for now, the current environment is one where Fed is still sounding marginally hawkish and FX volatility is still low. As such, yen is likely to remain a funding currency in carry trades, which will likely continue to add to yen’s headwinds. Going into Q2, the outlook of the yen could start to be more positive as Fed embraces rate cuts more openly, and that brings the risk of carry trade unwinding. The best running yen carry trade so far – MXNJPY – also faces risk from Banxico policymakers starting to sound more dovish lately and even considering a rate cut as early as the March 21 meeting, but even a 25bps cut keeps the carry attractive for now.
New regime for Japanese equities
Japanese stocks have had a great run last year and are up another ~20% YTD due to the many reasons we discussed in this article. Nikkei 225 was up another 0.7% on Tuesday, when BOJ announced a rate hike. This may be counter-intuitive but can be explained by a persistent weak yen and the BOJ move being well priced in.
The macro story for Japanese equities, like the one for the yen, rests more on the US and Fed side. As long as the fundamentals of the US economy stay robust and the Fed stays clear of a dovish tilt, Japanese equities may have room to rally. However, caution may be warranted in Q2 as Fed gets closer to rate cuts and that boosts the Japanese yen, in turn weighing on Japanese equities.
Still, the structural tailwinds for Nikkei, such as corporate reforms or geopolitics, continue to underpin. As such, a bottoms-up approach to investing in Japanese stocks may be considered. This could include stocks or ETFs that offer defensive and value exposures, such as MSCI Japan Value ETF (EWJV) or those that are tied to corporate reforms and dividends, such as the Nikkei 225 High Dividend Yield Stock 50 Index ETF (1489) or WisdomTree Japan SmallCap Dividend ETF (DFJ). Sectors or stocks that benefit from geopolitical shifts, such as semiconductors, could also continue to be interesting. In the wake of BOJ’s tightening, investors may also consider shifting exposure from exporters to firms that rely more on domestic demand and importers. Banks and financial institutions are likely to benefit from higher interest rates, which could improve their net interest margins. Conversely, higher borrowing costs could weigh on debt-laden sectors such as utilities and real estate.
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