Written by CC Japan Income & Growth Investment Trust manager, Richard Aston
The Bank of Japan served up a major shock to markets in July when it unveiled plans to introduce “greater flexibility” to its monetary policy.
In typical fashion, the central bank’s apparent shift away from its historically dovish stance was played down by Governor Kazuo Ueda. But the fact remains, many in the market now wondering whether Japan’s move away from negative interest rates is no longer a case of if but when.
The outlook stands to have a very positive impact on Japanese banking stocks. Particularly when you also consider their improving corporate governance standards along with the yen’s current weakness.
Throwing down the gauntlet
It’s important to note that July’s move by the BoJ was more of a tweak than a major shift. Particularly by the standards of many other central banks.
Ueda announced the introduction of more flexibility to yield curve control measures – a long-term policy that sees the BoJ buy and sell bonds targeting a specific interest rate.
The central bank will continue to allow 10-year Japanese government bond yields to fluctuate within 0.5% either side of its 0% target. However, it will now also offer to purchase 10-year Japanese Government Bonds at 1% through fixed-rate operations.
In other words, it has expanded its tolerance by a further 50 basis points.
Technical details aside, the key point for investors is whether the BoJ’s move represents the start of a more significant tightening cycle in Japan. Specifically, one that ushers in the long-awaited normalisation of interest rates.
The consensus right now, it seems, is yes. It will.
After all, Japan is very much an outlier on the global stage with its negative interest rate economy. Inflation, meanwhile, recently hit its highest level in four decades.
What is less agreed upon, however, is when this normalisation will take place.
Not only was the detail in last month’s update scarce, but Ueda went out of his way to avoid even mentioning tightening. “That’s not the case,” he said, when asked if the central bank had shifted from dovish top neutral.
Some of the CFOs I’ve spoken to on the ground believe we’ll see the BoJ’s next move around March/April next year. Given this will follow Japan’s next wage round, it seems like a strong bet.
Others believe ongoing weakness in the value of the yen will force the BoJ’s hand even sooner. Let’s not forget, it was only two months ago that Japanese policymakers were facing renewed calls to intervene as the currency slid past 145 per dollar.
As far as we’re concerned, such speculation is largely by the by. What’s more important, we believe, is interest rate normalisation now seems unavoidable in Japan – And we believe that this stands to benefit the banks.
It’s very difficult for these names to generate significant returns when rates are on the floor.
It reduces their profit margins as the spread between their borrowing costs and lending rates narrows. Not just that, but low rates can also deter savers from depositing money, reducing the pool of funds available for lending and investment.
It stands to reason, then, that the financial performance of Japanese banks should improve significantly as interest rates normalise from current levels. Unsurprisingly, this exact point was highlighted by the CFOs of all three of the nation’s largest players in their most recent results presentations.
This alone creates a strong entry point for investors – who knows where increasing balance sheet strength will take bank valuations from here?
But it’s important to note that this effect stands to be strengthened even further by the current weakness of the yen.
Indeed, should a normalisation of Japanese rates coincide with the end of the Fed’s current hiking cycle – or even US rate cuts – we would very much expect the yen to strengthen. If this happens, then Japanese banks won’t just have potentially more money on their balance sheets, but that money will be more valuable.
Beyond this, there’s also Japanese banks’ improving corporate governance standards to consider.
Many were unwavering in their dedication to improving their treatment of shareholders throughout Covid, maintaining dividends (as many of their global peers cut them) and buying back shares.
The good news is, this has only continued in the wake of the pandemic. Take Mitsubishi UFJ Financial Group, for example, which hiked its dividend from JPY¥32 to JPY¥41 in May after exceeding expectations in its FY 2022 results.
There seems a very good chance that interest rate normalisation could be back on the cards in Japan following last month’s announcement from the BoJ.
With the positive impact this could have on bank balance sheets with the potential reversing of yen weakness and the favourable backdrop of strengthening corporate governance standards, in our opinion Japanese banks look set to prosper over the longer term.
Richard Aston is portfolio manager of the CC Japan Income & Growth Trust plc