A line in the sand for the world’s largest creditor has been breached
Last week the Japanese yen crashed to its lowest level against the US dollar in 40 years, breaking through what was thought to be the Bank of Japan’s “line in the sand”. The yen’s weakness has implications for the rest of the world’s economies and financial markets, particularly America’s.
The yen crashed through 162 yen to the US dollar – the BoJ’s “red line” – hitting 162.51, before edging back up, to just above 161 yen to the dollar later in the week, when US payroll data suggested that the case for imminent US interest rate rises may have weakened.
There is a strong nexus between the US economy and its interest rates and currency, and Japan’s. The interest rate differential – the relationship between US and Japanese bond yields, drives the currencies’ relationship.
For decades, with the BoJ’s policy rate negative during Japan’s post-1980s era of economic stagnation, capital has flowed out of Japan in search of higher yields elsewhere, most notably in the US. The Japanese government, insurers, pension funds and individuals collectively hold more than $US1.2 trillion ($A1.73 trillion) of US government bonds.
It is the interest rate differentials, particularly the spread between US and Japanese rates, that created the decades-long “carry trade,” where foreign investors have borrowed cheaply to invest in higher-yielding assets elsewhere – government bonds, shares, property and other assets.
Japan has effectively been a source of ultra-low-cost funding for the rest of the world.
That started to change two years ago, when the BoJ raised its policy rate from below zero to 0 to 0.1 per cent. It has subsequently lifted it further, with the most recent move an increase from 0.75 per cent to 1 per cent last month.
Despite the increase in that rate, and significant movement in market rates – the 10-year bond yield has jumped from 2.06 per cent at the start of this year to 2.78 per cent and the 30-year yield from 4.85 per cent to 4.99 per cent – the differential with US rates and the opportunity for carry trade profits, while narrowing, has remained wide.
Moreover, for much of this year, with the US inflation continuing to rise – the core personal consumption expenditure rate favoured by the Federal Reserve Board rose 30 basis points to 3.4 per cent in May, well above the Fed’s 2 per cent target – the expectation in financial markets has been that the gap will widen.
Japan’s inflation rate, non-existent during the decades of economic winter, has also lifted and is pushing towards 2 per cent.
Its relatively new prime minister, Sanae Takaichi, however, has made it clear that she wants the BoJ to move slowly in tightening and normalising monetary policy – even as she has embarked on an expansive fiscal policy, including a $A190 billion stimulus package earlier this year and ambitious plans for ¥370 trillion of investment in artificial intelligence, semiconductors and other high-tech sectors between now and 2040.
That combination of cautious monetary policy tightening while the fiscal spigots are opened wide would normally be disciplined by the bond market, but with more than half the bonds in the Japanese market held by the government (along with major holdings of exchange-traded funds and real estate investment trusts build over a decade and a half) it isn’t a normal market.
It is the exchange rate that reflects the prospect that the spread between US rates and Japan’s may widen (unless the new Fed chair, Kevin Warsh, can somehow convince his Fed colleagues to ignore the rise in US inflation and deliver the rate cuts Donald Trump has demanded).
The BoJ has intervened in currency markets to try to arrest the depreciation of the yen, spending the equivalent of more than $A100 billion to try to pop the currency up.
It has a history of intervening – in the past it was usually to keep the yen from appreciating – but the impact of those episodes has generally been to smooth, rather than arrest, the changes in the direction of relative value.
That’s because, as long as the interest rate differentials with the rest of the world, the incentives to borrow cheaply in Japan to invest elsewhere remain. It’s a structural issue.
The markets are alert for further interventions. To defend the yen, the BoJ sells some of its foreign reserves in order to buy the yen. There is a concern that, if it were forced to support the yen for a prolonged period, it would have to sell off some of its largest offshore holdings, which are dominated by its US bond holdings.
As the largest foreign investor in the US Treasuries market – America’s largest foreign creditor – any large-scale sell-off of dollar-denominated assets would hit that market, raising yields and the US government’s already-rising borrowing costs.
With the US government debt on track to hit $US40 trillion within the next few months, and the second Trump administration as profligate as the first – it’s added more than $US3 trillion of debt in less than 18 months, after the first Trump presidency added $US7.8 trillion – rising yields and diminished liquidity in the bond market would add to the government’s borrowing costs and could create squeeze on the liquidity within the US financial system.
Indeed, any large-scale retreat by Japan from offshore markets would have global implications for bond markets that are already made more vulnerable by the massive volumes of government debt issued globally by central banks in responses to the 2008 financial crisis and then the pandemic. Pre-pandemic, global government debt was less than $US90 trillion. This year it could approach $US120 trillion.
The last thing the US or the world needs is for their largest creditor to reduce the flow of funds.
Takaichi doesn’t mind a weak currency because it makes Japan’s exporters more competitive in offshore markets and boosts her efforts to generate industry-led growth. It also has significantly boosted tourism.
Japan, however, imports most of its oil and gas and isn’t self-sufficient in food, so depreciation of the yen is fuelling inflation and pressuring household finances. There is a limit to how long and how much her government, with a debt-to-GDP ratio of more than 200 per cent, can keep compensating Japanese consumers for inflation.
Trump’s war on Iran hasn’t helped Japan, given what the combination of higher energy prices and a depreciating currency has done to the country’s energy costs.
For investors, how the tension between Takaichi’s desire to use expansive fiscal policies to normalise and grow Japan’s economy and complete the task embarked on by her mentor, Shinzo Abe, and the BoJ’s desire to tighten monetary policy to control the inflation rate and maintain currency stability play out is of enormous consequence.
Japan’s savings and its unconventional monetary policies have helped lower the cost of borrowing for the rest of the world for the best part of three decades. Any structural change in the relationship between its bonds and currencies and those of the rest of the world would matter – particularly for the US – and not in a good way.
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