Why Japan’s Exit From Negative Rates is Good for Global Investors

Forget the Fed decision today. The most earth-shattering central bank move has come on the other side of the globe.

It has finally happened. Japan … taikō drum roll please … has raised interest rates. Don’t fight the BOJ!

I’m being a bit facetious, but it is a sea change for Japan, which broke the mold by establishing negative interest rates in 2016. It was a highly controversial move at the time – some critics called it crazy – but it proved a path that most central banks proceeded to follow when they needed to stimulate the economy post-Covid.

This is the first interest-rate rise in Japan since 2007. It is significant because of what it represents: the final confirmation that Japan has exited its “lost decades” of deflation, with an economy that is back on track.

Front-running the shift

We have seen the markets front-run the improvement in Japan’s prospects, rising to record highs. Even though growth in Japan is slim, and dips in and out of negative territory, inflation is running around 2% in Japan. The central bank anticipates it will remain at that rate over the course of the next fiscal year, which in Japan runs through March.

Even more encouraging, the shuntō annual wage negotiations appear to be yielding the best results in years. Japan’s largest trade union, Rengo, says its 7 million members have locked in an average wage increase of 5.28%, the strongest in three decades, and up from the 3.80% locked in last year. The central bank has long argued that higher consumer prices must be accompanied by higher take-home pay to justify any end to its quantitative easing.

Technically, the Bank of Japan (BOJ) has made only a small move. It has shifted the short-term interest rate (actually the uncollateralized overnight call rate) from a negative range of 0.0% to -0.1% so that the central bank will now “encourage” the rate to remain very slightly positive, between 0.0% and 0.1%.

Surprisingly, the yen actually weakened from ¥149.21 to the U.S. dollar back up to ¥150.55 with the Tuesday announcement from the BOJ. You’d think higher rates make the currency marginally more attractive. But traders were put off by the language in the BOJ’s statement, which suggests the central bank will wait to see how these changes play out, and won’t make another quick move.

The yen has continued to weaken Wednesday. It’s at ¥151.66 to the dollar at the end of the day in Asia. It has been the worst-performing major currency so far this year, suggesting traders view this as a “dovish hike,” with rates due to stay at a similar level for the foreseeable future.

End to ETF and J-REIT buying

Equity markets are closed on Wednesday in Japan in honor of the spring equinox. The Nikkei 225 blue-chip index rose 0.7% Tuesday to close above 40,000 once again at 40,003.60, a significant barrier it broke for the first time on March 4. The broad-market Topix advanced 1.1% to end at 2,750.97. Although the Nikkei has blown through its 1989 high of 38,915, the Topix hasn’t yet tested its all-time high of 2,884.90 set in December 1989.

The biggest shift might actually be that the Japanese central bank will abandon its purchases of exchange traded funds (ETFs) and Japanese real-estate investment trusts (J-REITs). That was another form of quantitative easing and market support. The BOJ will continue its buying of Japanese government bonds (JGBs) in “broadly the same amount.”

So we can essentially say that the BOJ is shifting away and ending the era of QE and easy money. Still, borrowing costs remain exceptionally low in Japan, creating attractive carry trades for global allocators.

The BOJ had already adjusted long-term interest rates so that the yield on the 10-year JGB trades with a yield of up to 1.0%. Although that’s a “reference” rate, suggesting the yield can trade higher, the BOJ says it will “make nimble responses” should market movements test its limits. In other words, whether traders test the BOJ’s patience.

The BOJ vote was 7-2, so not its normal unanimous vote. BOJ Governor Kazuo Ueda said at a news conference that its QE policies have “become redundant” and have “fulfilled their role.”

A lot of the credit for shifting Japan out of inflation must go to Ueda’s predecessor, Haruhiko Kuroda, who came in with the late prime minister Shinzo Abe to unleash the three arrows of “Abenomics,” easy money being the first arrow to fire.

Kuroda, in his last days before stepping down in April 2023, was ridiculed for saying that higher prices in Japan were a good thing. He quickly clarified that wages would also need to be moving higher. But thanks to his policies, companies are in some instances taking the previously unacceptable step of raising prices. Consumers and companies alike who were used to goods and services being cheaper next year can no longer justify deferring spending and investment.

Another move in October?

Where do we go from here? Nomura’s economics team forecasts another rate hike in Japan in October, although economists are divided whether we will see a further move in 2024. The temporary yen weakness is due to the lack of specifics out of this meeting about the timing of future changes. But longer term, it’s likely rates will be rising in Japan and falling in the United States. So the yen will surely strengthen longer term against the U.S. dollar.

Japanese investors have also looked abroad to generate higher yields during the era of negative rates. They held US$6.1 trillion in overseas assets as of the end of 2022. Some of that money will likely find its way home, which suggests further growth for Japanese assets.

Ueda, a soft-spoken academic, was ridiculed as “Who-eda” when chosen as central-bank governor. He was not the first choice but then-deputy governor Masayoshi Amamiya declined the role, saying he had orchestrated negative rates so should not be the ones to end it.

Still, Ueda has pledged to communicate BOJ intentions and direction more clearly, and has been quick to change central-bank guidance and policy. At his very first policy meeting last April, he already indicated that the central bank was ditching its QE bias, then last July he adjusted the permissible range for 10-year bond yields.

He has done a good job of indicating where the central bank will head. Currency weakness will be a concern, and perhaps the next challenge he will tackle. But he has ended Japan’s long experiment with negative rates.