Bank of Japan Sees ‘Opportunity’ as Fed Leans Toward Interest Rate Decision
Are we in a Goldilocks phase? The answer has profound implications for where currencies and stocks head next.
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Are we in a Goldilocks moment?
That’s what Naka Matsuzawa, the chief macro strategist at Nomura Securities, is asking himself.
The implications are key. Particularly for currencies, with a knock-on effect for stocks.
Central Bank Pairing May Diverge
If Goldilocks is at home, presumably tasting the bears’ porridge, it’s likely we will see a weaker U.S. dollar. Nomura anticipates no rate hike at the U.S. Federal Reserve Open Market Committee (FOMC) meeting on September 15 to 16.
Meanwhile, it’s locked in that we would see a rate increase when the Bank of Japan (BoJ) meets on monetary policy a couple of days later, on September 17 to 18. On Tuesday, we just got a wage report showing real wages rose 2.4%, the biggest increase since May 2021 and the seventh straight rise. Base pay rose the most since 1992 — with the BoJ demanding that it sees consistent wage growth if it’s going to act on inflation and higher prices.
Sea Change in the Yen?
The pair of central-bank meetings could prompt a sea change in the direction of the U.S. dollar-Japanese yen pairing.
“A Fed decision to skip a rate hike would be a good opportunity for the BoJ to resolve its behind-the-curve position,” Matsuzawa wrote in a note to clients.
Policymakers, he added, would have to accept an equity correction driven by further yen appreciation.
In fact, we are already seeing currency traders position themselves for a more hawk-like BoJ. This would be the quickest rate hike under Japanese central-bank chief Kazuo Ueda, who became BoJ governor in April 2023.
Sudden Shift of 6.6%
I’ve been following the moves in the Japanese yen with avid interest, as readers will know. After hitting levels last seen in 1986, just shy of ¥164 to the U.S. dollar in late July, it has suddenly strengthened to ¥153.07 on Tuesday.
That’s a shift of 6.6% in a short spell of time. While the initial leg downward was caused by the joint U.S.-Japan intervention into currency markets on July 31, much of that effect waned over the next few days.
This latest strengthening is apparently happening organically. That’s far more meaningful.
Dollar Down 2.0% by Year End
Nomura is positioning itself for dollar weakness in the medium term, anticipating a fall of around 2.0% in the U.S. dollar index (DXY) by the end of the year. Dovish positioning by the Fed would curb dollar strength.
The strong U.S. jobs report on Friday nevertheless showed a stable labor market, turning attention to the producer price report on Thursday and consumer prices on Friday.
An interest-rate hike is very much in the balance. The prediction market Kalshi is pricing in a 53% probability of a rate hike.
There’s a case that U.S. Federal Reserve Chairman Kevin Warsh will hike to prove his inflation-fighting chops. I agree with Nomura that rates will likely remain steady — but it’s a coin toss.
Despite hawkish posturing from Warsh, Fed Governor Christopher Waller has spoken out to say he’s leaning toward keeping rates steady at the Fed’s meeting later this month.
Waller did add that he’ll be “heavily influenced” by the August inflation data later this week. But while inflation remains “meaningfully above” the Fed’s 2.0% target, he said recent macro trends “suggest we are finally seeing some signs of disinflation,” he told Reuters.
“If this continues in the data due over the next two weeks, I would be inclined to support holding the target rate for the federal funds rate at its current setting,” he added.
Nikkei 225 Hit Hardest
I should note that the equity correction we would see from a stronger yen would be most dramatic in the stocks of “Japan Inc.” major exporters that populate the Nikkei 225 index.
The broader Topix, up 16.5% year to date, has lagged the Nikkei, up 25.9% on the way up. It should hold up better if there’s a correction in Japanese blue chips.
Those are the companies that we typically think about when we mention Japanese stocks: the likes of Uniqlo parent Fast Retailing (FRCOY) (T:9983), which gets around 60% of its sales overseas, and Toyota Motor (TM) (T:7203), where the share of sales from outside Japan is even greater, around 75%.
The figure is highest for Japanese chipmakers, which have surged this year. Tokyo Electron (TOELY) (T:8035) gets some 90% of sales from abroad, as does Kioxia Holdings (KXIAY) (T:285A). For my pick among Asian equities this year, the chip-testing equipment maker Advantest (ATEYY) (T:6857), that figure is 97%.
Exporters Benefit from Weak Yen
Those export producers have been benefitting from the weak yen, since money made overseas looks even better when translated back into their home currency. Tech stocks that are borrowing to grow rapidly would also suffer from higher borrowing costs.
Domestic companies that make their profits within Japan, on the other hand, would instead benefit from lower costs on energy, commodities and other imports. They will be comparatively better off.
That’s why I have recommended the WisdomTree Japan SmallCap Dividend Fund (DFJ). This exchange-traded fund (ETF) excludes the 300-largest companies in the WisdomTree Japan Dividend Index, then weights the rest by their dividends paid. It should therefore capture the universe of Japan-focused Japanese companies.
Domestic Companies Better Off
These dividend-paying companies are, presumably, not borrowing heavily to fund expansion. They are mature companies like the construction contractors Infroneer Holdings (T:5076) and Hazama Ando (T:1719).
Japan’s long-suffering regional banks should also benefit from higher rates. The largest component in DFJ is Daishi Hokuetsu Financial Group (T:7327), which mainly serves Niigata Prefecture, known for its hot springs and skiing. Just behind in terms of weighting sits Chugin Financial Group (T:5832), serving largely rural Okayama Prefecture.
Domestic stocks should hold up better even under slightly higher interest rates. What will be interesting to watch is whether we see an unwinding in the “carry trade” that has seen yen shorting and borrowing to buy other currencies and higher-yielding assets.
It looks like positioning on the yen is changing. Citigroup is indicating that money flows have turned yen-bullish since the start of August, with the yen also rising against currencies such as the euro and Australian dollar.
Tectonic Plates Shifting?
Stephen Jen at Eurizon SLJ Asset Management told Reuters that we are seeing the early rupture of the carry trade.
“When a currency is so extremely undervalued, and positioning is so extended, movements like this one will occur increasingly frequently before a big move,” Jen explained. “It’s a bit like earthquakes. The tectonic plates are grating on each other with great forces.”
Higher bond yields are also encouraging the repatriation of foreign investment by Japanese institutional investors. Earlier this month, the 10-year Japanese government bond (JGB) hit a yield of 3.0%, the highest since 1996.
If inflows back into Japan continue, we must watch for any sudden unravelling of the carry trade, as briefly happened in August 2024. That’s when an unexpected BoJ rate rise and U.S. recession fears triggered a “flash crash” in the Nikkei 225, which lost one-fifth of its value in a handful of trading days, including a 12.4% drop on August 5, 2024, alone.
This time around, traders are almost certain the BoJ will raise rates. They won’t be taken by surprise, but will be watching for the central bank’s language on where rates are heading. We will see after September 18 how strongly the yen continues to move.
At the time of publication, McMillan was long DFJ.
