Speculation is rising about whether the Japanese Government is going to use its enormous currency reserves to defend the value of yen. While it may make some limited interventions, it won’t be for long, according to Aegon Asset Management’s Hendrik Tuch.
Tuch, head of fixed income (Netherlands) at Aegon AM, says Japan is facing a much weaker yen in the near future as its economic conditions materially worsen, but it is “useless” to defend the currency as long as the Bank of Japan (BoJ) sticks to its current monetary policy.
“At first glance, Japan does not seem to be a prime candidate for a weakening currency as its combined corporate and private saving rate is still a whopping 25%, while inflation is still below 3%,” he says. “But these numbers are expected to worsen quite a bit as Japanese savers are forced to spend more, and inflation starts to rachet up courtesy of yen weakness.
“The Japanese Government deficit is expected to improve a bit now that Covid-19 measures have been lifted but must remain high to stimulate lacklustre economic growth. Which brings us back to the main culprit of the yen weakness – the monetary policy of the BoJ.
“As long as it sticks to its policy of a maximum of 25 bps yield on 10-year Japanese government bonds, it is useless to even try to strengthen the yen. If current monetary policy does not change, Japan is facing a cycle of weakened currency, higher inflation, followed by more currency weakness.”
Tuch says that while monetary and fiscal authorities in Japan have plenty of form for tinkering with financial markets, they are unlikely to intervene substantially to defend the value of the yen this time, preferring to rely on monetary policy changes.
“The BoJ is certainly no stranger to manipulating financial markets, considering it is already holding 43% of all Japanese government bond debt and about 7% of Japanese equities. Japan has an enormous $1.2 trillion piggy bank of foreign reserves too. That is some firepower at the start of what would be a potential lengthy currency intervention.
Tuch notes that there was a temporary rise of the yen after the Bank of Japan, the Ministry of Finance and the Financial Services Agency in a combined statement expressed their concern about the pace of its decline and would ‘act appropriately if needed.’
“But the effect of this statement was limited to a few hours,” Tuch said, “as the US CPI number drove down equity markets and caused further dollar strength so Japanese financial authorities will indeed have to act if they want to change the current trend.
“Can you imagine how history will judge Mr Kuroda and his team at the BoJ if they let inflation run out of control in a country filled with retired risk-averse savers?
“It is likely that the Japanese authorities will first try to stem the yen weakness through interventions but subsequently decide it is better to adjust the BoJ’s monetary policy. Just as in previous cycles, the BoJ will be the last of the major central banks to start a rate hike cycle and at that point the global economic cycle has probably passed its peak.”
Looking at the investment opportunities, Tuch says that while investors have been able to profit from higher yielding carry strategies in relation the yen, the change of direction in BoJ monetary policy will bring this to an end.
“Since the start of this year, the yen has lost about 17% of its value versus the dollar and more than 10% on a trade weighted basis. Adding the losses during 2021 we get to a yen depreciation of almost 30% in 18-months’ time, with financial markets ready to push the currency down further.
“Even though the US two-year rate has come off from its highs, at around 2.8% yield the spread versus short-dated Japanese government bonds remains comfortably above 3%, the highest level since 2007.
“Investors looking for carry strategies now have plenty of choice in selecting higher yielding government bond markets versus the Japanese bond market,” Tuch said,
“While equity markets have lost about 15% year-to-date, a long Brazilian real versus yen strategy would have gained more than 35%.”
“The upcoming BoJ’s change of its policy stance will correspond with the peak of the economic cycle. The BoJ’s change will bring an end to the carry strategy party and will add to the global restrictive monetary policies which continue to weight on financial markets.”
