What Does Japan’s Surprise Central Bank Move Mean for Global Investors?

Japan moves to the beat of its own drum. I’ve often found on my visits there that little things like turnstiles will operate in the reverse direction from what a Westerner might expect. And that’s true in terms of rates now in Japan, famed for so long for its super-easy money, where the cycle is moving in reverse.

As we wait for the U.S. Federal Reserve to cut interest rates, a move likely to come in September, and with countries such as India already moving into an easing cycle, Japan has started to hike rates. The central Bank of Japan ended its rates meeting on Wednesday with the decision to move its policy rate from the current range of 0.0% to 0.1%, up to 0.25%.

It’s a surprise move. Market watchers weren’t sure of the central bank’s direction until it made the call. Markets had attributed a roughly 33% chance for the bank to raise rates now.

The central bank is also halving its purchases of Japanese government bonds (JGBs). This all follows the Japanese central bank’s first rate hike in 17 years, when it opted to take rates out of negative territory this March, a move that I noted at the time should be good for global investors.

And that’s proven to be the case. Japanese stocks have been on a rip for the last couple of years, taking the market to recent all-time highs. The broad-market Topix is up 42.9% since the start of 2023. Those are heady gains for a market that long languished in the weeds.

We will need to watch whether these interest rate hikes, the first since 2007, have changed the game.

The Dow-like Nikkei 225 ended the day down 2.5% on Thursday, the first chance for investors to respond to the rates call, as the Japanese yen strengthened. The broad-market Topix, the equivalent of the S&P 500, lurched 3.2% lower.

The Japanese currency has strengthened sharply since mid-July. It has moved from ¥161.77 on July 10, 2024, to ¥150.73 on Thursday, a gain of 6.8% in three weeks.

Of course, the yen has been shockingly weak. I’ve lived in Asia since 2001, and my quick mental math always counts on the U.S. dollar being worth “around 100.” It’s been a shock to the system to see the currency crest above ¥130, then ¥140, and even north of ¥160.

A great time to buy Japanese assets, or travel to Japan. It seems that this period of supreme yen weakness has likely come to an end.

The yen actually lost ground when the BOJ first raised rates in March. That was a surprise — higher rates should lead to currency strength — but traders were disappointed with the language surrounding the decision, which suggested the central bank wouldn’t rush to continue the tightening cycle.

But it is tightening, gradually. This actually relieves some of the pressure that had been building on the central bank. Japan imports all of its oil, which is priced in U.S. dollars, and any other raw material costs more to ship into Japan. So, long term, the weak currency leads to higher input costs, higher manufacturing costs, and ultimately rising prices and higher inflation.

The yen weakness has been great news for Japan’s largest multinationals, which generate revenue overseas that is inflated by a slack currency when they send the proceeds back to Japan. But it is bad for domestic consumers and smaller companies, both of which must pay higher for anything not entirely made in Japan. Consumers even cut back on some spending due to higher prices, hurting domestic small businesses, who were facing both higher input costs and reduced demand.

The BOJ forecast at this meeting that inflation will stay around 2% through fiscal 2026. But the central bank warned that import prices are accelerating again, despite some recent moderation, necessitating vigilance that inflation doesn’t overrun expectations.

“There is a possibility that wage growth and inflation may overshoot, accompanied by heightening medium- and long-term inflation expectations, amid a tight job market,” the BOJ said on Thursday, as it issued the full version of its quarterly-outlook report.

Nomura believes this latest hike should help households by supporting real wage growth, suppressing the inflationary weakening of the yen, and by increasing household purchasing power for savers who are now at least yielding a little interest on their holdings.

“This view may well hold true now, but is not necessarily true as it relates to future rate hikes, since such a series of rate hikes would start to have a negative impact on private capex and housing investment,” noted Nomura’s Japan economist Kyohei Morita and its global foreign-exchange strategist Yujiro Goto.

They believe this hike does not necessarily mean we will get a whole series of rate hikes in a row. Morita and Goto think this tweak to rates is an “adjustment within an accommodative range,” rather than the start of tightening.

Data released Thursday show that Japanese stocks saw heavy outflows from foreign investors in the week through July 26, 2024, with net selling equivalent to $10.5 billion. That’s the largest net selling since September 2023.

We can assume that the selling represents international portfolio managers getting their holdings set ahead of the BOJ’s decision. Higher rates are necessary in Japan because the economy is on a firmer footing.

We should watch carefully for any signs that these rate hikes are hurting the Japanese economy, and Japanese stocks. But ultimately, this week’s hike comes only because the Japanese economy is doing well.

I would expect Japanese stocks to cease their selling and resume a generally positive trend. It’s likely, but not assured, that a virtuous cycle of higher wages, higher prices, higher rates and a stronger economy will ensue.