Introduction
The Japanese economy is often found to be intricate, complicated, and confounded, characterised by headlines like the lost decades, deflation, sluggishness, and a low-desire society. It is still one of the largest economies, trailing behind only the United States and the People’s Republic of China, despite the fact that the economy has barely grown relative to other industrialised economies since the well-known real estate burst back in the 1990s. Japan was the first in Asia to industrialise and join the global superpowers by accepting Western institutions, technologies, and culture during the Meiji Restoration in the 19th century. The extensive embracement of technologies has turned Japan into a futuristic nation of neon-lit metropolises with the world’s fastest Shinkansen and leading status in automation and robotics. Japanese macroeconomic policies, such as quantitative easing (QE), negative interest rates, and yield curve controls, were also ahead of other advanced economies, which then provided valuable lessons when they confronted deflationary financial crises after 2008. Simultaneously, however, Japan is also awkwardly “stuck in the past”, held back by a deep-entrenched Japanese culture that is resistant to change (see Wingfield-Hayes, 2023).
Some brief glossary:
Quantitative easing: the involvement of the central bank in purchasing long-term government bonds or other assets (asset-backed securities and could even include stocks in the case of Japan) to push down long-term interest rates and borrowing costs, offloading debt securities, and support corporate valuations and stimulate investment
Negative interest rates: as its name suggests, happens when a central bank establishes a target nominal interest rate that is lower than 0% to discourage cash hoarding that will lose value due to negative deposit rates.
Yield Curve Control: is a monetary policy tool used by central banks to target interest rates at a specific level by buying varying amounts of government bonds or other financial assets. See below for a more detailed explanation.
Japan had its “lost decades” from 1991 to 2021, which can be attributed to a number of factors including the bust of the late 1980s to 1990s real estate and equity bubbles, natural disasters, inappropriate fiscal and monetary policies, and an ageing demographic conundrum. During this time, Gross Domestic Product (GDP) growth and inflation averaged 0.7% and 0.4%, respectively, notwithstanding a few brief spikes (see Kochugovindan, 2023). In 2023, Japan garnered much excitement about future growth prospects from international investors, which marked a momentous change after decades of sluggishness. The Japanese economy grew 6% in the second quarter of 2024, beating many expectations owing to robust exports (CNBC, 2023). Morgan Stanley Research (2023) expects Japan’s nominal GDP growth to approach 5% in 2023, its highest since 1991. Nikkei 225, the Japanese stock index, breached its 33-year high (Wagatsuma, 2023). Warren Buffett also notably announced his explicit build-up of a large stake in five Japanese conglomerates. Wages and prices rose at their fastest pace in more than 30 years (The Economist, 2023), which will have implications for the conduct of the Japanese monetary policy. The global macroeconomic landscape is aware of and heightened by the potential alteration, which will be discussed shortly. But first, we are going to look at a few trading patterns that have emerged globally over the past few decades as a result of the Bank of Japan’s (BoJ) ultra-loose monetary policies.
Carry Trade and Widow Maker
Owing to its ultra-loose monetary policy regime, which includes large-scale QE, afterwards qualitative and quantitative easing (QQE), yield curve control (YCC), and an unprecedented negative policy rate under former prime minister Shinzo Abe and former BoJ’s governor Haruhiko Kuroda, the central bank flooded its financial system with cheap yen, sending the currency overseas in search for better yields. Japan’s external net assets stood at 418,628.5 billion yen, or around 75% of its Gross Domestic Product (GDP), making it a net creditor for 32 consecutive years (The Nikkei, 2023; see also FRED database).
It also fuelled another popular trading method among international foreign currency (forex) traders, dubbed carry trade. Carry trade typically involves borrowing one currency at low interest and investing in another higher-yielding currency to earn the interest rate spread. The yen became the poster boy, and it became a no-brainer for investors to borrow from the excess savings of Japan with low or negligible interest rates while leveraging it to maximise profits by parking the money anywhere yields are higher throughout decades. From April to June 2018, the United States (US) dollar to Japanese yen (USDJPY) earned traders a 4.5% profit (Kondo, 2018). It is apparent this year that major central banks have diligently hiked their rates except BoJ, which had kept its rate at -0.1% with no explicit forward guidance of normalisation. Even the previous vice president of Berkshire Hathaway Charlie Munger praised Warren Buffet’s bet on Japan, saying that it was “awfully easy money”, owning to Japan’s historically low interest rates that allowed borrowing money cheaply as far as 10 years in advance to acquire other high-yielding assets (CNN Business, 2023).
Widow maker trade emerged as the other side of such extensive monetary easing pursued by BoJ. In finance and trade, a widow maker simply refers to an investment that apparently results in devastating losses for everyone who tries it. When BoJ slashed interest rates to negative in 2016, the bank also came up with the idea of YCC to facilitate the formation of a robust yield curve (see Kihara, 2023). In simple terms, the BoJ is committed to purchasing any amount of Japanese 10-year government bonds in order to suppress its yield at near 0%. Note that bond prices and yields are inversely related; an increase in demand (reckless purchase from BoJ) will drive up the bond price and hence, suppress its yield. As such, the BoJ allowed the depreciation of yen due to an unlimited amount of bond purchases or QE to cap the 10-year yield at 0%, further facilitating the carry trade mentioned above. The widow maker trade, which in this case involved short-selling ostensibly mispriced Japanese government bonds, had survived its failure for decades from the early 1990s (Financial Times, 2023). Its supporters, who consistently wagered that things would be different, were rendered to be increasingly naive to challenge BoJ. It is even astounding to find out that BoJ has purchased 53% of the total 10-year government bonds ever circulated in the market as of March 2023 (nippon.com, 2023).
Mixed signals moving ahead and consequences of BoJ’s normalisation
Let’s first go straight into the possible consequences. Japan has contributed to increased global liquidity in recent years and has played a role in driving down yields globally. In this context, the reversal of this strategy may contribute to a regime shift where the repatriation of assets and funds back into Japan and an increase in world yields occur, particularly when major policy rates are still high. Japanese investors have started selling stakes in overseas markets across various asset classes that previously yielded higher returns in 2022 (Rovnick et al., 2023). Japanese investors own 6% and 4.1% of Australian and French bonds, respectively; while being the largest overseas holder of US Treasuries (Rovnick et al., 2023). The European Central Bank (ECB) warned in its financial stability report earlier this year, stating that “A shift away from the low-interest rate environment in Japan could test the resilience of global bond markets” (see Reuters, 2023a). Note that the size of the global fixed-income market is significantly larger than the equity market.
BoJ has been awaiting sustainable inflation above the target of 2%, driven by wage growth. In other words, the return of a dynamic labour market, corporate renewal, and robust internal demand. Headline year-on-year inflation has overshot the BoJ’s target for 20 consecutive months even though much is due to imported costs (see YCharts). Prices for around 90% of items monitored by the BoJ are rising, and corporates are retesting the consensus where pushing up prices could lose customers (The Economist, 2023). Japanese Trade Union Confederation, also known as Rengo, has demanded a pay hike of at least 5% in 2024 Shuntō negotiations (Kyodo News, 2023). The largest trade union has successfully helped its workers win an average raise of 3.58% this Spring, exceeding 3% for the first time in 29 years (Kyodo News, 2023). Shuntō refers to the annual pay discussions between employers and trade unions between February and March.
BoJ has been tweaking its YCC policy more frequently starting from December 2022, when it loosened the YCC band that allowed the yield of Japanese 10-year government bonds to fluctuate within an upper and lower limit of 0.5%. In July 2023, BoJ stated that the 0.5% band will be set as references, not a rigid limit while offering purchases of bonds at the 1.0% level. In October 2023, it further loosened the band to ± 1.0%. The Japanese yen appreciated significantly to a three-month high on the 7th of December, where investors priced in the potential early pivot by the BoJ following a visit of the incumbent governor, Kazuo Ueda, to the Prime Minister’s office to discuss economic and financial conditions (Menghani, 2023). The assertion was also echoed by the deputy governor the day before, who noted that households and businesses may benefit from the central bank’s decision to abandon its ultra-loose policy (Central Banking Newsdesk, 2023). However, the latest BoJ monetary board meeting on 18th and 19th December showed mixed signals, where there was a unanimous vote to maintain the current monetary policy stance, followed by a dovish press conference by the governor. “I don’t think the chance is high for us to say abruptly that we will hike rates at a subsequent meeting,” Mr Ueda said in response to a question on the potential of a policy adjustment during the much-anticipated meeting in January (Reuters, 2023b). The BoJ mentioned that they must see a clear sign of sustainable inflation at the 2% target, virtuously driven by wage growth, before rolling in any contractionary policies. Furthermore, the disastrous earthquake that haunted Suzu, Japan, at the beginning of 2024 further complicated the normalisation path of the BoJ.
Conclusion
A change in how prices and wage-setting behaviour could be prompted by the post-pandemic inflationary pressures and a few years of relatively high wage rises, which could lead Japan towards a higher inflation regime. As such, it could constitute a meaningful shift in domestically generated inflation. This year, the BoJ has been gradually normalising its policies by removing restrictions on its 10-year yield target and allowing for greater policy flexibility by modifying the phrasing and wording of its guidelines. In 2024, more moves to withdraw from its ultra-accommodative policies are probably in order, albeit policymakers are still keeping an eye out for any long-term increases in wages and inflation. Although BoJ officials’ comments about a date for a policy reversal are still unclear, the market is pricing in Japan abandoning its negative rates in the second quarter of 2024, after the 2024 Shunto wage negotiations. Japan’s exit from yield curve control and negative interest rates will be symbolically important for the global financial landscape, but interest rates will remain relatively low as compared to its peers (Kochugovindan, 2023).
References
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CNBC. (2023, August 15). Japan GDP grew 6%, easily beating expectations on robust exports. CNBC. https://www.cnbc.com/2023/08/15/japan-q2-gdp.html
CNN Business. (2023, November 1). ‘Awfully easy money’: Charlie Munger praises Warren Buffett’s big bets on Japan. https://edition.cnn.com/2023/11/01/investing/munger-interview-buffett-japan-investment-intl-hnk/index.html
Financial Times. (2023, January 13). Japan’s ‘widow-maker’ trade has finally come good. https://www.ft.com/content/ebd78dba-844f-49f4-a28b-bb546d3fd37f
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Kondo, M. (2018, August 15). Dollar-Yen carry trade just got more alluring, thanks to BOJ. Bloomberg.com. https://www.bloomberg.com/news/articles/2018-08-14/dollar-yen-carry-trade-just-got-more-appealing-thanks-to-boj
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Wingfield-Hayes, B. R. (2023, January 20). Japan was the future but it’s stuck in the past. BBC News. https://www.bbc.com/news/world-asia-63830490
Researcher(s): Yeoh Jia Xin
Reviewer(s): Maryam Nazir Chaudhary
Editor(s): Waywen Loh
