Japan's Financial Odyssey: From Negative Interest Rates to Carry Trade Unwinds
Despite US equity markets coming off a summer of multiple S&P 500 all-time highs, the most recent of which occurring on September 17th, the ride to the top has not been without its own speedbumps. The most notable of which coming after a relatively surprising decision by the Bank of Japan to raise rates to 0.25% from the previous range of 0-0.1%. The resulting sell-off in the U.S. equity markets, especially for tech stocks, displays the remarkable interconnectivity of modern global markets. This intertwinement brings us to the question: Why would a 15-basis point increase of the Japanese policy rate be the main cause for a 6.21 percent decrease in the value of the S&P 500 over the next 3 days?
The answer is the emergence, and subsequent unwind of the carry trade. A carry trade is when you borrow in a country with low interest rates and invest in higher-yielding assets elsewhere in the world, your profit being the difference in borrowing costs and investment yield. This style of trade’s popularity exploded recently amongst vastly different interest rate environments in the United States and Japan, with an extended period of high rates (5.25-5.5) in the U.S., and near-zero rates in Japan. This rate divergence offered investors the opportunity to capitalize on cheap capital and a weak yen by first, borrowing in Japan, converting the yen to USD, and then investing it in higher yielding American assets. If exchange rates and policy rate differentials hold steady, the result is a cost-free profit. However, this summer it became clear that, through cooling inflation numbers and economic indications of a weakening U.S. job market, the U.S. was due to start a cutting cycle sooner than later. This prompted investors to, begin closing their carry positions. Then, unexpectedly, the Bank of Japan hiked rates and, the carry trade fell apart. Traders rushed to close their positions, selling their USD denominated asset of choice, and buying yen to cover their loans, heavily pushing the exchange rate up. The effect on U.S equity markets can be observed in Figure 1, which illustrates the simultaneous decrease of USD/Yen, and the S&P500’s value. The sudden unwind of the carry trade is just the latest chapter in Japan’s history of unconventional monetary policy, which has frequently sent ripples through global financial markets. To understand why the Bank of Japan’s decisions has such far-reaching consequences, we must first look at the country’s unique monetary evolution; from pioneering zero interest rate policy (ZIRP) and quantitative easing, to protectionary measures to prop up its currency.
Figure 1: USD/JPY exchange rate (blue) vs. S&P 500 (red)
Long History of Unique Monetary Policy
The first and possibly most notable of Japan’s innovative monetary policy was the introduction of zero rates in the 1990’s in response to the collapse of the Japanese asset price bubble (“The Lost Decade”). Later in 2016, Japan took it one step further and implemented negative interest rates and yield curve control (1% cap on 10-year bond yields) which they held until two hikes earlier this year. Typically, zero and negative interest rates are saved for the direst of economic circumstance, when attempts to stimulate an economy during a recession push rates close to zero or into the negatives. In Japan however, negative interest rates became a staple throughout the last 10 years due to an extended period with low economic growth, a rapidly aging workforce, and a battle against deflation. This circumstance only reinforced the Bank of Japan’s reputation as having the most unorthodox approach among central banks. Another innovative measure started by the Bank of Japan is quantitative easing – the purchase of securities (usually debt instruments) on the open market by the central bank to stem growth in the economy. Quantitative easing achieves this by increasing the liquidity in the market, pushing down bond yields, and therefore increasing banks’ appetites to lend. The Bank of Japan was the first central bank to implement QE, after a period of zero interest rate policy failed to achieve the aforementioned goals, by buying Japanese Government Bonds. QE has since been implemented as a basic method of controlling money supply across the majority of central banks.
Transition to “Normal” Monetary Policy?
Despite this substantive history of aggressive policy, the central bank has seemed to usher in a new era of monetary policy under Kazuo Ueda. Earlier this summer, he started the shift to normalization for the bank’s monetary policy, hiking interest rates above zero for the first time since October of 2010. He also ended yield-curve-control, giving hope to investors who are looking for higher yields in the long-term bond market. Hopefully, regional banks that currently hold long-term Japanese government debt have better risk management practices than the Silicon Valley Bank, whose exposure to low yield bonds ultimately led to its bank run last year. With wage increases happening steadily, and inflation consistently above the 2% equilibrium (as seen in Figure 2), Japan is set up well for a full-scale shift to normalization in it’s monetary policy, aligning with the current modernized economy.
Figure 2: BOJ Policy Rate vs. Japanese Inflation
As evidenced by the carry trade, Japan’s abnormal policy can produce negative effects across asset classes domestically. Due to the vast difference of interest rates in Japan compared to other developed economies, it has steadily pushed the yen’s value down. Before the carry trade unwind (May 2024), the yen had lost a third of its value against the U.S dollar since the start of 2021. Despite the currency being commonly heralded as a “safe-haven asset”, due to Japan’s status as a creditor with strong economic fundamentals, yen volatility has forced investors and central bank officials to take notice. Going forward, Japan faces challenges with an aging population, shrinking workforce, and inconsistent growth, pushing the Bank of Japan into the limelight. The central bank now has a large responsibility to protect the stability of domestic markets, especially in traditional safe havens like the yen and Japanese government bonds. Should the yen’s volatility become the norm, foreign investment could be deterred, leading to capital outflows and downward pressure across Japanese assets. The country’s central bank must find a balance between aggressive monetary policy, intervention in foreign exchange markets, and a shift towards normalization. This is important to not only protect Japanese assets classes, but to promote growth in a shrinking economy.
Figure 3: Japanese Bond Yields in Response to Policy Normalization
To conclude, Japan’s monetary policy has long been a global outlier, with its unconventional strategies like zero and negative interest rates, quantitative easing, and yield curve control being implemented throughout its turbulent economic times. The recent rate hike, the first in over a decade, marks the beginning of a shift towards policy normalization and an ignited optimism for the state of affairs in Japan’s economy. As a result, investors should not only pay attention to valuations and pricing when investing in Japanese assets, but also the rhetoric coming out of the central bank which has much stronger market implications than other countries. Moving forward, the Bank of Japan faces a paramount stretch of decision making as it navigates the ensuing shift to normalization, striving to balance promoting growth – without undermining stability – and control over inflation/deflation risks.