Growing interest rate spread leaves the yen remarkably cold

The interest rate differential between Japan and the Western world is widening due to interest rate hikes in Europe and the United States. However, this is no longer at the expense of the yen. Slowly but surely, a significant change of course is taking place at the Bank of Japan.

Interest rates have risen somewhat further in recent weeks in many countries. The US Federal Reserve (Fed) has reluctantly raised its policy rate by 25 basis points to 4,75%. Given all the problems with Silicon Valley Bank and other local banks, the Fed probably would have preferred to hold the rate for a while longer. The Bank of England (BoE) also unintentionally raised interest rates slightly. BoE chairman Mark Carney said a few weeks ago that he preferred to wait and see developments after ten rate hikes in a row.

Instead, a sudden rise in British inflation forced Carney to raise interest rates again. ECB chairwoman Christine Lagarde had already raised interest rates with conviction in an attempt to push down the stubbornly high European inflation. Japan is the only major developed economy where interest rates have not yet risen sharply. Slowly but surely, however, a major landslide is taking shape in the country's interest rate policy.

All bonds on the balance sheet
The Bank of Japan (BoJ) is reaching the limits of policy. The central bank has been trying to stoke the inflation fire in Japan for more than a decade. Because Japan has an old, shrinking population, it's a bit more difficult to grow spending than in many other countries. In a last-ditch effort to get people and businesses to borrow and invest a little more, the BoJ has pushed down long-term capital market rates in addition to short-term policy rates.

The central bank does this by buying government bonds on a large scale. However, the BoJ is so enthusiastic about this that it now has more than half of Japan's government debt on its balance sheet. As a result, the trade in these loans has partly come to a standstill. This is obviously not a sustainable situation. On Sunday, April 9, Kazuo Ueda will take over from Haruhiko Kuroda as BoJ chairman. Then Ueda faces the big challenge of gradually bringing interest rates back to normal levels and ending the BoJ's addiction to buying government bonds.

Policy envelope
The first chance he will get for this is at the end of April. Financial markets shuddered briefly at the end of 2022 when the BoJ slightly expanded the long-term interest rate range from 0,25% to 0,5% above or below 0%. More and more parties are already opting for a first interest rate increase. For example, investors in Japanese equities no longer hedge currency risk, while hedge funds buy the currency because they are afraid to take a position in the stagnant government bond market.

Thanks to these flows of money, the yen barely budged when interest rates in the Western world went up this month. Once Ueda loosens its iron grip on long rates, the currency could come out of the dark corner that the yen has been in for years. But first, the currency world needs some patience: it is almost a month before the BoJ meets on April 27 to discuss interest rates.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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