Equity Guru readers have been kept up to date on all things Japan. I have been speaking about the incredible opportunity in the Japanese markets given the depreciation of the Japanese Yen. I started sounding the alarm bells back in 2022, warning about the eventual move by the Bank of Japan and how it is the most consequential central bank. It appears all of that is now taking place. More on this later.
The Bank of Japan kept interest rates in negative territory during a time other major central banks were raising rates to combat inflation.
The greatest investor, Warren Buffett, pounced on the opportunity in Japan. Very simple investment thesis: Japan has a lot of value companies that do not change much but bring in consistent profits. A weaker yen tends to help exporter shares as it increases the value of overseas profits in yen terms when companies repatriate them to Japan. This has led to stellar corporate earnings for Japanese companies.
This has seen the Japanese Nikkei stock market take out 1989 highs and break out into new all time record high territory. A high that I was telling readers would break given the current set up. Details were provided in the article, “Why I am Buying Japan“.
However, things have become even more interesting with Japan raising interest rates in March 2024 for the first time in 17 years. Historic… and something I have warned about.
As a major analyst said in March 2024: “Something big in Japan is about to happen,”
A weaker Yen is driving concerns of rising inflation in Japan. The classical economists feel validated seeing inflation as a monetary phenomenon. A weaker currency means Japan is importing inflation and exporting deflation according to classical economics.
And the Bank of Japan is worried that a weak Yen will drive inflation. This could mean big things for the global markets.
In previous articles, I have stated that Japan and not China, is the largest holder of US debt. Yes, the Chinese have been dumping US debt, including a record sell off of $53.3 billion worth of treasury’s. But things could get even more shaky in the US debt market if Japanese debt begins to be sold off. By the way, this all comes when a recent US debt auction came in as a flop.
With Japanese interest rates in the negative, Japanese money (remember those Japanese boomers?) had to look elsewhere for yield. Japanese money has been buying foreign debt. In a way, doing indirect yield curve control for foreign nations. Simply put, if Japanese money was to sell off foreign debt to come back to Japan, it would cause yields to spike, leading to a rise in rates, as bonds are being dumped.
As of yet, there is not a large incentive for Japanese money to sell foreign debt. But if the Bank of Japan was to normalize rates… money could return to Japan. The large debate among contrarian investors is what rates need to be to incentivize Japanese money to sell off foreign debt. Some say this would never happen because Japan would need to raise a lot to make domestic debt appealing. Others say it would not have to be much, aiming for 1% in BoJ rates.
Whether Japan can even raise rates high enough is a debate given this:
They are the most indebted when it comes to gross debt in percentage of GDP.
But onto the main show. The Japanese Yen.
The Japanese Yen is getting smashed against most currencies. The reason has to do with interest rate differentials and overnight swaps. While most of the Western allied world began raising interest rates to tame inflation, Japan kept rates unchanged at -0.1%. This means anyone who shorts the Yen through the foreign exchange market, or buys any other currency against the yen, makes a pretty penny just in holding overnight due to the interest rate differentials. You can see why many traders and funds who play forex would want to short the yen… and when we are talking tens or hundreds of millions of dollars, the overnight swap return provides a good return.
The Bank of Japan has taken rates back to the positive with its first hike. But will it be enough to dissuade investors and traders from betting against the Japanese Yen?
In my opinion: no. The interest differential is still large meaning the carry trade is still there. I expect any dips to be bought.
Now the Bank of Japan has a few options to strengthen the Yen. The Bank of Japan can make hawkish statements trying to ‘scare’ Japanese shorts. Diction alone can move markets without action. The Bank of Japan can intervene by selling off foreign reserves to strengthen the Yen. Or, they need to raise interest rates.
Option 1 hasn’t been working.
I have been speculating that the line in the sand for the BoJ is 150-155. But it seems it is 160. I have been expecting the BoJ to intervene, and this has been confirmed last week with the BoJ confirming its first currency intervention since 2022 with $62 billion between April 26 and May 29. You can see that price action on the chart with the big red candle around 158.
But will this be enough to shift the trend?
As of now, it is too early to tell. It looks like the Yen could strengthen, falling to the higher low zone around 154. But with the current fundamental set up in interest rate differentials, I still expect buyers to step in and continue to short the Yen. Remember: if you hold the Yen, you are losing money on overnight swaps. If you bet against it, you are earning free money on overnight swaps.
Thus, it comes down to how serious the Bank of Japan will be in defending the Yen.
It seems to have come down to interest rate hikes being required. Rakuten Group CEO Hiroyuki Nagai believes the Bank of Japan will take action to raise interest rates in October at the latest:
“Now that the Bank of Japan has scrapped its negative interest rate policy, earnings and profits for financial institutions will increase significantly as interest rates rise,” Nagai said. “We’ve already begun to benefit, and we believe we will receive even more benefits than we do now if the BOJ continues to raise rates.”
The CEO also acknowledged Japan’s debt situation. While Nagai does not expect big rate hikes due to Japan’s current economic conditions, there could be a negative impact if the BOJ raises rates beyond 25 basis points, such as a rise in defaults as some individuals and businesses will not be able to repay their debt.
But if they don’t, the currency will continue to weaken.
As I said, a very important and pivotal moment in the global debt markets. Something big is definitely brewing in Japan. A hawkish Bank of Japan is a black swan which would cause volatility in the global debt markets causing rates to rise. Keep an eye on the Japanese Yen and the Bank of Japan as this central bank in Asia continues to be consequential for you and your money.
Happy Trading.