Shifting Tides: The yen's influence on global markets amidst changing monetary policy

By Sophia Samilski

*Photo by Manuel Cosentino, from Unsplash*

In the Western world, interest rates have surged, with Bank of Canada’s overnight rate reaching 5% and the U.S.’s federal funds target rate ranging from 5.25% -5.50%. In contrast, the Bank of Japan (BOJ) has maintained its negative interest rate policy of -0.1% since 2016 until only recently, making its currency, the yen, a favourite among global investors. Taking advantage of Japan’s low borrowing cost, along with its weakened currency, investors aggressively borrowed in yen and invested across global markets. This phenomenon not only positioned Japan as the world's largest creditor, as net external assets rose to a record $3 trillion in 2023, but also underscored its influence in the global asset markets. This was evident this summer, when Tokyo Stock Exchange’s Nikkei 225 experienced its biggest single-day drop of 12.4% and the S&P 500 lost 3%, marking its worst day since September 2022.

In the early 1990’s, Japan faced a dramatic collapse of its real estate and stock market bubble, setting off a chain reaction that plunged the economy into a prolonged period of sluggish growth and intermittent recessions. To stimulate spending and revitalization, interest rates were kept exceptionally low, often hovering around, or even below 0%. Japan’s historically low interest rates also contributed to the weakening of the yen and prompted investors to participate in a high-risk, high-reward strategy known as the carry trade. For a small fee, investors borrowed Japanese yen and used it to purchase currencies with higher yields, which was then used to purchase high-yielding assets like government bonds, and more recently, risky equities. At the end of a usually short-term trade, investors convert the dollars back into yen, and repays the loan after achieving high returns. While this may appear to be a straightforward arbitrage opportunity, the carry trade is heavily dependent on the borrowing currency remaining cheap, and the market remaining stable.

In March 2024, the bank raised interest rates for the first time since 2007, to a range of zero to 0.1 %, ending its eight year period of negative interest rates.

"The elimination of negative interest rates in particular signals the BOJ's confidence that Japan has emerged from the grip of deflation." Frederic Neumann, chief Asia economist at HSBC in Hong Kong told Reuters

Wage increases, rising inflation, and improved consumer spending, signals that the country may finally be emerging from its decades-long stagnation. Major companies have agreed to raise wages by 5.28% for 2024, marking the largest pay increases in 33 years. And for the last 2 years, Japan’s inflation has stayed at or above the BOJ’s 2% target. Japan's Consumer Price Index (CPI) recorded a year-over-year increase of 2.8% in February, 2024.

Despite the positive signs emerging from Japan, global markets experienced a significant downturn this summer, initially driven by concerns over a slowing U.S. economy. The United States Department of Labour reported the unemployment rate increased to 4.3% in July, the highest level since October 2021. Additionally, on July 31st, the Bank of Japan raised rates for a second time this year, increasing them to 0.25 %.

These developments heightened risk aversion among investors and signaled a narrowing yield gap. As a result, traders rushed to unwind their carry trades, selling equities and other risky assets purchased by borrowing in yen, which caused the yen to appreciate. From early July to early September, the yen strengthened significantly, rallying from nearly ¥162 to the U.S. dollar to just under ¥140.

“Investors started to unwind positions at the end of last week, but as the yen strengthened and the Nikkei fell, more and more were forced to close the trade and sell into a one-way market today,” Ben Bennett, head of investment strategy for Asia at European asset manager Legal & General Investment Management told The Wall Street Journal.

Trading volume in Tokyo on August 5th was more than double the daily average for the past year. The S&P 500 marked its worst day since 2022, while The Nikkei 225 dropped more than 12%. The Magnificent 7 lost $800 billion in market value.

“The reality about the yen carry trade is that nobody exactly knows how big it is, or how much has now unwound. But there is certainly a sense at this stage that some of the shakiest yen shorts that were funding speculative trades have been wiped clean,” said Benjamin Shatil, a currency strategist at JPMorgan in Tokyo in an interview with the Financial Times.

While many believe speculative short-term positions have been unwound, uncertainty remains, leaving investors cautious as they closely monitor the actions of the Bank of Japan and the yen.

The BOJ is widely expected to leave the benchmark rate at 0.25% on October 31st. BOJ Deputy Governor Ryozo Himino, said the central bank will continue to raise its benchmark rate if the economy performs in line with its projections at an event hosted by Bloomberg in Tokyo. If the Bank of Japan hikes rates a third time this year in December, it could narrow the interest rate differential between Japan and other countries, making the yen less attractive for carry trades. At a recent Bloomberg conference, a former executive at the BOJ, Kazuo Momma said if the yen depreciates to as far as ¥150 or ¥155 it may lead to the BOJ hiking rates earlier than expected.

October 17th marked the yen's weakest closing level since July 30th, highlighting the risk of currency intervention by the BOJ. The currency dropped to ¥150.21 per dollar, after two consecutive weeks of drops for the yen.

Traders have dialed back bets on potential rate cuts from the Federal Reserve, weighing more heavily on the yen as strong economic data emerged from the U.S. labor market. 254,000 jobs were created in September, surpassing expectations.

Looking ahead, investors are cautious about the potential risks posed by the upcoming elections in both the U.S. and Japan.

Ultimately, the upcoming months promise to be consequential for global investors and the yen as the Bank of Japan and Federal Reserve navigate their economic objectives in the face of uncertainty.