By Chen Li
The significant depreciation of the Japanese yen (JPY) against the U.S. dollar (USD) has become a major concern in the current financial markets. As the USD gradually strengthens, the JPY continues to decline. Following the historic breach of the JPY 154 per USD mark on April 22 in the foreign exchange market, the USD against the Japanese currency surged past 155 on April 24, reaching a 34-year high. The JPY is similarly weak against other major currencies, with the euro reaching a historical high against it at 166 and the pound approaching a 10-year high at nearly 194. Why then, does the depreciation of the yen seem unstoppable?
The JPY is a major global safe-haven and funding currency for carry trades, making its exchange rate highly correlated with the U.S.-Japan bond yield spread. When Japanese bond yields are lower relative to U.S. ones, it implies a lower return on investment in the yen, resulting in fewer investors opting for it and thus the depreciation. The current sharp decline in the JPY can be attributed to two main factors: carry trades driven by the widening of the real interest rate differential between the U.S. and Japan, and short sales of the JPY based on expectations of the U.S.-Japan interest rate differential.
In order to stimulate the Japanese economy, which had languished since the bursting of the real estate bubble at the end of the last century, the Bank of Japan (BoJ) implemented unprecedented monetary and fiscal stimulus policies, even resorting to “printing money” and inventing quantitative easing (QE) to keep long-term bond yields at extremely low levels. This in itself fuelled yen depreciation and also triggered carry trades in the foreign exchange market, leading to further depreciation. Due to Japan’s “long-standing stability” in low interest rates, the JPY is typically used as the funding currency target in carry trades. Many international investors borrow JPY at low-interest rates to invest in USD assets, causing yen outflows from Japan’s domestic capital market. This is also the reason why Japan holds a huge amount of overseas assets. Especially with the divergence in U.S. and Japanese monetary policies, the U.S.-Japan bond yield spread has widened from its low point in 2020 to the current 376 basis points, leading investors to prefer to carry trades and resulting in a sharp decline in the JPY.
The bad news is, that market expectations for a near-term narrowing of the U.S.-Japan interest rate differential are rather pessimistic, exacerbating carry trades in the JPY and short selling of it. With the U.S. economy showing robust growth momentum, a highly resilient labor market, and lingering inflationary pressures, the Federal Reserve has recently been increasingly hawkish, slowing down the pace of interest rate cuts for the year. The market has pushed back expectations for a Fed interest rate cut to September, with some analysts even suggesting that there may be no rate cuts at all this year. Japan, closely monitoring the Fed’s monetary policy, naturally dares not to raise interest rates hastily. Additionally, with the Japanese economy still lacking resilience in the aftermath of the pandemic and per capita disposable income declining after adjusting for inflation, the BoJ is concerned that raising interest rates could lead to economic contraction. Therefore, it could only raise interest rates symbolically by 0.1% after the annual “shunto” wage negotiations which did not elicit a positive market response. Judging from recent statements by the BoJ, raising interest rates also does not seem to be on the agenda in the near future.
In early April, BoJ Governor Kazuo Ueda reiterated that they would not consider changing monetary policy directly in response to forex fluctuations. However, his tone softened slightly at a recent meeting of G20 finance ministers and central bank governors, suggesting that if basic prices improve, interest rates may be further raised. Overall, market expectations for changes in monetary policy between the U.S. and Japan are not high, thus massive shorting of the JPY has led to its depreciation. The latest data from the Commodity Futures Trading Commission (CFTC) shows that as of the week ending April 19, leveraged funds and asset management companies’ net short positions in the yen had increased to 165,600 contracts, the highest level since January 2007.
The continuous decline of the JPY will bring widespread adverse effects to the Japanese economy. Generally, a weaker yen may benefit Japanese exports, leading to increased profits for exporting companies. However, due to the depreciation of the currency, Japanese exports calculated in USD are actually in decline. The latest export data from Japan shows that in March, Japanese exports increased by 7.3% year-on-year, but the volume of shipments decreased by 2.1% year-on-year, and exports calculated in USD decreased by 5.8% year-on-year. Meanwhile, the lower JPY has increased the attractiveness of the Japanese stock market, creating a prosperous scene. However, Morgan Stanley emphasizes that when the JPY exchange rate falls below 152, the returns for overseas investors in the Japanese stock market, calculated in USD, begin to decline. The Japanese stock market may start to underperform compared to its American counterpart, which could have a negative impact on it. In addition, for Japan as a major importing country, the depreciation of the JPY leads to higher prices for imported goods, potentially causing input-driven inflation and burdening consumer spending, thereby affecting the country’s domestic demand. It is also expected that small and medium-sized enterprises (SMEs) will be severely affected by the depreciation of the JPY. SMEs account for 99.7% of the total number of Japanese companies, with employees accounting for 70%. The excessive depreciation of the JPY exacerbates wage pressure, which may overwhelm these SMEs, as well as the entire economy.
The Bank of Japan cannot afford to ignore the losses caused by the depreciation of the yen, so when and how to intervene in the foreign exchange market has become a topic of concern for the market. Stephen Inglis, Global Head of G10 FX Research and North America Macro Strategy at Standard Chartered Bank, believes that Japan is “very, very close” to intervening in the yen. According to a report from Bank of America on April 22, the level of 1 US dollar to 155 yen is the “bottom line” for the Japanese Ministry of Finance, and intervention will be conducted if the yen falls below this level. However, since April this year, the Bank of Japan has been “talking more than acting” on market intervention, allowing the yen to depreciate further until now， when the USD/JPY exchange rate has surpassed the high of 155. Currently, even if a decision is made to intervene, the Bank of Japan is inclined to use traditional methods to control the exchange rate, namely selling US dollar assets and buying yen assets. However, this operation requires massive funds and can cause turmoil in the bond market, and is constrained in practical application, making it not a sustainable measure.
In 2022, the Japanese Ministry of Finance spent approximately USD 60.6 billion three times to support the JPY exchange rate. In October of the same year, Japan’s holdings of foreign securities decreased by USD 43.9 billion compared to September. According to the recent Treasury International Capital (TIC) report released by the U.S. Treasury Department, Japan, as the largest holder of U.S. bonds, saw its holdings of U.S. bonds increase for the fifth consecutive month, with positions further increasing by USD 16.4 billion to USD 1.1679 trillion in February of this year, an increase of USD 87.2 billion from the same period last year. If Japan intervenes in the foreign exchange market, it will have to sell some of its U.S. bonds, which will put greater upward pressure on U.S. bond yields, potentially triggering a bond crisis and dissatisfaction from the United States.
Most importantly, such intervention in the foreign exchange market does not change the expectation of the persistently high U.S.-Japan interest rate differential. Arbitrageurs will still seize the opportunity to take advantage in this and continue to short the yen, leading to further depreciation of the currency. Regarding this, ANBOUND’s founder Kung Chan pointed out that the effective way to put the brakes on the JPY depreciation is through interest rate hikes. Now, the BoJ’s decision to raise interest rates should not be the usual starting point of focusing on the economy or price levels but instead should instead target the speed of JPY depreciation, striving to encourage its holding rather than selling.
When it comes to the causes of yen depreciation, the BoJ’s indecision regarding interest rate hikes is a significant factor contributing to its depreciation. This partly stems from concerns about impacting Japan’s economy, as higher financing costs could lead to credit tightening for businesses and households. More importantly, there is the looming pressure of government debt. Data shows that the scale of Japanese government bonds as a percentage of GDP is close to 220%, ranking first globally. However, the benefits of interest rate hikes should not be overlooked. On one hand, raising interest rates can narrow the U.S.-Japan real interest rate differential, reducing arbitrage trading pressures on the JPY and dispelling market expectations of maintaining or widening interest rate differentials. This effectively curbs the trend of yen short-selling, putting a brake on its depreciation. On the other hand, after interest rate hikes, the JPY will appreciate, prompting investors to sell overseas assets and buy Japanese assets, leading to a yen inflow and its subsequent appreciation. Additionally, higher yen yields will invigorate Japan’s financial system. Finally, Japan’s economy has recovered significantly from the pandemic, and there is inherent inflationary pressure, leaving some room for interest rate hikes. In conclusion, interest rate hikes may be the best approach to prevent JPY depreciation.
Final analysis conclusion:
Due to the continuous widening of the yield spread between U.S. and Japanese government bonds, arbitrage trading and short-selling against the yen have caused the Japanese currency to depreciate continuously. Moreover, the negative effects of its depreciation are gradually becoming apparent. The “nominal” prosperity of Japan’s exports and stock market will ultimately be difficult to sustain. These factors compel the Bank of Japan to take intervention measures. Traditional intervention operations in the foreign exchange market are costly, only address symptoms, and are unsustainable. On the other hand, raising interest rates will not only change the yield spread between the U.S. and Japan, as well as reduce arbitrage and short-selling transactions. Hence, from the perspective of economic logic and Japan’s macroeconomic environment, interest rate hikes are necessary. As it stands, raising interest rates may be the best approach to put a brake on yen depreciation.
Chen Li is a researcher at ANBOUND
