Japan is the world’s third-largest economy, and as such, the Japanese Yen is one of the most traded currencies globally.
As a result, Japan’s monetary policy significantly impacts investors worldwide. For years, Japan’s economy has struggled with deflation – or falling prices – and had negative interest rates from 2016 until earlier this year.
However, in March 2024, the Bank of Japan (BOJ) raised interest rates for the first time in 17 years, marking an important exit from negative rate territory.
By moving its short-term interest rate from -0.1% to a range of 0-0.1%, the BOJ signalled its confidence that the recent inflation in Japan’s economy could be here to stay.
But what does the end of Japan’s negative interest rate policy mean for investors?
Potential For Riskier Investment Assets To Perform Well
It suggests the potential for riskier investment assets to perform well.
One of the biggest issues the Japanese market has faced over the past three decades has been deflation, which has resulted in rock-bottom yields for Japanese Government Bonds (JGBs).
For many years, JGBs’ perceived safety had the unintended consequence of attracting the savings and investment dollars of Japan’s ageing population. Consequently, the country’s stock market languished, never coming close to the previous highs it hit during the 1989 bubble.
Yet, with the exit from negative rates, Japan’s stock market has become much more attractive for local and international investors. The Nikkei 225 Index – Japan’s main stock market benchmark – hit an all-time high in February 2024, surpassing the previous peak set in 1989.
Sources: LSEG, Nikkei, Reuters as of February 2024
Over the past year alone, as it became clearer that the BOJ would raise interest rates, the Nikkei 225 Index has advanced 20%. Having reached nearly the 41,000 level in late March, it pulled back and currently sits at around 39,200 (as of 25 June 2024).
Yet the key theme is clear: Higher interest rates from the BOJ and the return of inflation in the Japanese economy are boosting stock sentiment.
Falling Bond Prices, Rising Yields In Japan
As riskier asset classes, like stocks, have become popular again, more traditional and risk-averse assets (such as bonds) have suffered.
In the world of bonds, higher yields mean falling bond prices and vice versa. The BOJ’s monetary stance and the economic data at the time saw JGBs suffer their worst quarterly sell-off in 25 years in the third quarter of 2023.
After the BOJ raised its interest rate in March, and markets expected further hikes ahead, the JGB 10-year yield climbed into 2024. In late May, the yield on 10-year JGBs surpassed 1% for the first time in 11 years.
Japan’s 10-year government bond yield (%)
Source: Finimize, Bloomberg
In mid-June, the BOJ stated that it would also “significantly” reduce its JPY 6 trillion (US$38 billion) monthly bond-buying programme.
That bond-buying was part of its ultra-loose monetary policy and was done in a similar fashion to the quantitative easing (aka “QE”) bond-buying that the US Federal Reserve (Fed) deployed in the wake of the Global Financial Crisis in 2008-2009.
Weaker Currency Means Hedging Out Risk
Despite Japan’s exit from negative interest rates, the Japanese Yen remains weak. One of the biggest reasons for this is the disparity between the BOJ’s interest rate and that of the rest of the world.
The US Federal Reserve has maintained its interest rate at a relatively high 5.25%, attracting investors to the US Dollar and away from the low-yielding Japanese Yen.
With central banks in the UK, Europe, Australia, and Canada also keeping interest rates in the range of 4-5%, the attraction of other currencies versus the Yen remains strong.
As a result, the weaker Japanese yen has hampered the US Dollar returns of international investors’ investments in Japan.
This is evident in the data. For example, the MSCI Japan Index is up 19.5% year-to-date in Japanese Yen terms (as of 31 May 2024) but has only seen an increase of 7.2% in US Dollar terms over the same timeframe.
For investors who continue to view Japan as a long-term investment opportunity, it has made sense to invest in currency-hedged funds or ETFs. This helps hedge against currency risk.
Looking To Long-Term Growth From Higher Rates
While the end of Japan’s negative interest rate environment has led to a fall in bond prices and its currency, Japanese stocks have performed well.
Overall, ending negative rates is a positive development for the Japanese economy, as many economists view entrenched deflation as more dangerous than high inflation.
Additional reasons to be optimistic about Japanese stocks include corporate governance reforms and increased share buybacks and dividends.
However, the BOJ’s monetary policy will continue to play a significant role in determining how investors view Japan as an investment opportunity.
Read Also: Guide To Investing In Japanese Indexes And ETFs
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