The falling yen tells a painful story

In the developed world, central bankers are awakened by high inflation. In the Netherlands, it rose from 5,2% to 6,1% last month. Japan, however, is the big exception. There, the central bank is unable to stoke the inflation fire, so that the yen continues to sink.

The financial world held its breath for a while at the end of 2022. Would Japan finally release its iron stranglehold on interest rates? A widening of the narrow range in which the Bank of Japan (BoJ) has locked interest rates was seen as an advance on a very different policy. In Japan, the central bank has kept both the short-term policy rate and the ten-year capital interest rate around zero for years in an attempt to fuel inflation somewhat. The extremely low interest rates make it more attractive for consumers and businesses to borrow money for major purchases and investments. The idea is that this will speed up economic growth, so that prices will go up and voilà: inflation will creep towards the 2% that the BoJ would like to see.

Theory and practice: a world of difference
At least that's the theory. The practice looks very different. In April, inflation in Japan rose to 4,1%, the highest level in more than forty years. However, this has more to do with the passing on of rising energy prices and problems that have arisen in supply chains in recent years than with BoJ policy. However, research shows that inflation expectations of households are still very low and that SMEs are struggling to implement the wage increases stipulated in the collective agreements of large companies. These are indications that the higher inflation is mainly a temporary phenomenon, rather than the structural step that the central bank would like to see.

Unintended side effects
In addition, the BoJ's policy also has unintended side effects. International investors are much more eager to borrow money in Japan at extremely low interest rates than domestic households and companies. These investors borrow billions of euros every month at the very low interest rates in Japan, to invest this capital in other parts of the world at a higher return. This flow of money increased the value of various assets such as US equities, European real estate and raw materials from Latin America. As soon as interest rates in Japan start to rise, the so-called 'carry trade' will become a lot less attractive. A rate hike by the BoJ therefore reverberates through the financial markets.

Blank
Traders are now breathing a little more calmly. The broadening of the interest rate range five months later looks more like a blank slate than a shot ahead. Only if inflation remains at or above 2% for a longer period of time and companies actually raise wages will an increase in interest rate targets for the short and long term be discussed. Until then, much remains to be done. Even under chairman Kazuo Ueda, who took office at the beginning of April, the key interest rate in Japan has not moved, while it has skyrocketed in the rest of the developed world. In view of the carry trade, this is good news for equity investors and those planning a holiday in Japan. The Japanese currency has fallen by more than 2020% against the euro since the beginning of May 20. As long as the interest rate differential continues to widen, nothing stands in the way of a further fall in the yen.

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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