Striking yen rally has shaky foundations

The rise of the Japanese yen is in the spotlight on currency markets. It was only a matter of time before the currency would recover somewhat after a sharp decline. But traders are thus far ahead of a move by the Bank of Japan.

The Japanese yen has fallen by more than 2021% against the dollar between the beginning of 30 and mid-November. That correction is not as severe as the fall in the exchange rate of, for example, the Argentine peso (-77%) or the Turkish lira (-74%). Yet the decline is striking, because these types of price falls are not common for currencies of large, developed countries. Such a correction is usually the result of a major recession or a major natural disaster. In the case of the yen, however, the currency woes are caused by inflation that spiked after 2021. To get inflation under control, interest rates shot up everywhere. In the United States the policy interest rate is currently 5,5% and in Europe it is 4,5%.

Interest rate violence
The Bank of Japan (BoJ) is really not going along with this interest rate frenzy. Japanese interest rates have been below zero since 2016. With extremely low interest rates, the BoJ is trying to boost consumer spending and business investment. That was desperately needed in the past decade. Inflation in the country has only briefly risen above 2010% since 2014 in 2, before inflation was fueled by the corona pandemic. Inflation currently fluctuates around 3%. And that is the perfect excuse for the BoJ to carefully increase the extremely low interest rates. In that sense, 'careful' is the key word. Because if Japan's central bank acts quickly, the consequences may be incalculable.

'Carry trade'
The very low interest rates make it attractive for investors to borrow money in Japan and invest it in another country at a higher return. This so-called 'carry trade' has only become more attractive in recent years because interest rates have risen almost everywhere in the world, with the exception of Japan. Hundreds of billions of euros worth of yen have now been borrowed and invested abroad. As interest rates continue to rise, more and more of that money will flow back to Japan. The BoJ's policy is therefore being felt on stock markets worldwide. In view of the enormous capital outflow due to the carry trade, traders have started to speculate en masse on a further fall in the yen.

Slowly but certainly
Slowly but surely, the time is approaching when Japanese interest rates will rise. Although there is a very small chance that there will be an interest rate move at the BoJ meeting early next week, many parties are choosing to be safe and closing their short positions. As a result, the yen suddenly shot up 6% since mid-November. According to many economists, this recovery movement is premature. But in doing so they underestimate the conviction with which the BoJ is preparing for an interest rate move. Last Wednesday, board member Ryozo Himino provided a sharp analysis of how higher interest rates affect the economy. Perhaps the yen rally of recent weeks is indeed a bit premature, but sooner or later the interest rate turnaround in Japan will definitely happen.

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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