The Bank of Japan's Dilemma
The Most Dangerous Safe Haven
“If a problem can be solved, then it’s not worth worrying about it. If it can’t be solved, then it’s useless to worry about it.”
― Japanese Proverb
Those who follow the market have probably heard about the drastic devaluation of the Japanese Yen (JPY) in the past month (Figure 1). For those who don’t follow the foreign exchange market a rising USD/JPY is a weakening yen as it takes more yen to match the value of $1 USD. Since COVID, there have been multiple significant headlines regarding large devaluations of nations’ currencies from the Turkish Lira, Russian Ruble, and the Sri Lankan Rupee more recently. Currency devaluation is not a rare phenomenon within emerging market countries like the ones previously mentioned, but what’s different about the yen is its historical reputation as a safe haven asset. For those who don’t know, safe-haven assets have stable demand, liquid markets, strong relevance within the market, and will retain value in times of market turbulence. These can range from metals such as gold, U.S. Treasuries, and currencies like the Swiss Franc (CHF), Japanese Yen, and the U.S. Dollar (USD).
Figure 1: USD/JPY Sell-Off
In the past year or so, the dollar has been on a tear. Despite 40-year high inflation in the U.S., the dollar has been sustained by three main macro drivers. First is the safe haven aspect previously mentioned, as rising geopolitical risk and market uncertainty cause investors to seek quality assets, and what’s a better store of value than cold hard cash (well, all commodities and any asset that hasn’t lost 8.5% of their value in the past year). The second is the globalized nature of inflation. It stems from inefficacies within the global supply chain to meet strong demand from wealthy consuming countries and has since spilled over into most countries. Yes, the 8.5% CPI YoY headline is bad, but it’s not an isolated incident. Think about it in the old analogy of getting chased by a bear, or in this case inflation. You, the U.S., don’t need to outrun the bear to survive. All you need to do is to outrun your friend next to you, other countries. The final and most important driver is what the Fed has been doing to combat inflation, raising interest rates (Figure 2).
Figure 2: Rising Yields Are Driving The Dollar
Given that currencies are evaluated on a relative basis, usually to the dollar, this has caused devaluations of many currencies unless you are a commodity exporter, which Japan is not. What sets the yen apart from other currencies is not only the drastic nature of the sell-off for such a safe currency. It is a symptom of a disease that has been plaguing the Japanese economy for the past two decades: Japanification.
Brief History Lesson
I won’t dive too deep into the idea of Japanification, but to understand why the yen is depreciating, one has to understand the unique state of the Japanese economy. In the 1980’s, Japan became a manufacturing and exporting juggernaut as the world moved towards globalization. At the same time, the U.S. was coming off the gold standard, letting the dollar float. The dollar soon became the preferred payment method for oil exporters, ushering us into the petrodollar stage. High demand and floating nature gave the dollar, and therefore the American consumer, significant purchasing power, letting them buy higher volumes of goods for cheaper from countries with weaker currencies like, you guessed it, Japan. This sparked a wave of Japanese imports, the effects of which can still be seen today, as Toyota was the top-selling car manufacturer in the U.S. in 2021.
Figure 3: Effect Of American Purchasing Power On Japanese Stocks
As the dollar appreciated, U.S. exporters struggled to find demand for their products. To bolster U.S. exports, the U.S. agreed with other major countries at the Plaza Accord to devalue the U.S. Dollar (Figure 3). This did not go over well for Japanese exporters as they found a drastic decrease in their primary customer’s purchasing power. At the same time, Japanese equities and real estate markets that were heavily overvalued were about to burst. Long story short, Japan faced a severe economic slowdown just as its population growth leveled off (Figure 4).
Figure 4: Japan YoY Population Growth
This lack of population growth caused the median age of Japan to rise. In 2022 the median age in Japan is 47.3 years compared to the global median of 30.9 years. This population aging has had a deflationary effect on the economy since. According to a Bank For International Settlements study, adults between 30 and 60 tend to have a deflationary impact. They produce more than they consume, given that they are deeper into the workforce than a recent college grad who just took out massive student loans. This age range is more focused on saving than borrowing, which means they benefit more from deflation increasing their savings rather than inflation reducing their debt. This is bad for a central bank trying to jump-start a struggling economy as expansionary monetary policy and modern economies depend on credit to succeed. It just so happens that Japan’s median age of 47.3 years sits at the trough of this relationship, shown in Figure 5.
Figure 5: How Does Age Affect Inflation?
How To Unsuccessfully Deal With Deflation
This has left the Bank of Japan (BOJ) in a tricky spot as they have had to find new monetary policy methods or aggressively push old ones to force Japan out of its deflationary spiral. Do you think the size of the Fed’s balance sheet is bad after over a decade of quantitative easing? The BOJ was one of the earliest adopters of QE and holds a similar-sized balance sheet to the Fed, but when adjusted for the size of the two economies, the BOJ’s QE vastly outpaces the Fed’s (Figure 6).
Figure 6: BOJ Was Printing Bank Reserves Before It Was Cool
The extreme dovish attitude of the BOJ is the not-so-secret answer to the problem of a devaluing yen. While everyone is rushing to hike rates to combat inflation, the BOJ maintains its dovishness. This is because Japan is still a percent below the BOJ’s inflation target of 2%. While everyone is worrying about inflation increasing, the BOJ sees signs of inflation moving to its long-term target (Figure 7).
Figure 7: Japan Headline CPI YoY%
This push to 2% has made the BOJ maintain expansionary monetary policy measures. The most important right now is the idea of yield curve control (YCC) (Figure 8). YCC is the idea for a central bank to set a longer-dated interest rate and then buy or sell bonds to get to the target rate. This is different from the Fed’s QE as the market prices in rates that are based on the set amount of bonds being bought by the Fed (among other things). Here, the BOJ buys and sells bonds (Japanese Government Bonds “JGBs”) based on what the market is setting as the equilibrium interest rate to meet their target of 0.25% on the 10-year JGB.
Figure 8: Japan Yield Curve V.S. U.S. Yield Curve
The YCC policy has led to a vast yield difference between Japan and other developed nations like the U.S., and this difference in interest rates is the primary reason why the yen has been selling off (Figure 9). Despite the yen’s rapid devaluation, the BOJ continues to buy bonds to suppress yields.
Figure 9: The U.S. Is Leaving Japan In The Dust When It Comes To Hiking Rates
Implications Of A Weak Yen
At this point, you might be thinking, “wait, isn’t a weak yen what drove Japan’s expansion in the ’80s?” You wouldn’t be wrong. Typically, a weakening yen has resulted in a strengthening Japanese economy or at least an appreciation in Japanese equities. However, in recent months this relationship has harshly diverged (Figure 10)
Figure 10: Yen And Nikkei Separate
Yes, Japan is the 4th largest exporter and is a net exporter, but it is important to look at the goods they are importing and exporting. As a manufacturing country, Japan typically exports electronics, cars, and refined commodities. More important, are Japan’s imports. Japan happens to be the 5th largest importer of crude oil and imports many raw commodities, which they then turn into finished goods. Now, a weakening yen may be increasing demand for exporters within the country, but the rapid rise in oil prices and other raw material inputs have outpaced the price of the finished goods (Figure 11). A weakening yen also means it’s now more expensive for Japan to purchase inputs, causing margins to get crushed. To summarize, the price of goods Japan is importing is rising faster than the price of goods that Japan exports.
Figure 11: Weak Yen And High Commodity Prices Are Dangerous For Japan
Margin pressures can be directly seen when comparing Japan’s CPI and PPI. Margins for Japanese companies are getting squeezed to the lowest levels since the early 1980’s as producers fail to raise prices to keep up with higher input costs (Figure 12).
Figure 12: Japanese Margins Are Shrinking
The question then becomes, will the BOJ step in to save the yen by opening the yield curve flood gates and letting interest rates float? The answer is probably no. Looking at Figure 13, historically, when the BOJ intervenes in the currency yen, volatility tends to be much higher at a mean of 20.7% but was only 9.6% a week ago.
Figure 13: When Does The BOJ Step In?
This is a lose-lose situation for Japan as if they let the yen further depreciate, margins for Japanese companies will contract further and the buying power of the Japanese citizen will rapidly decrease, spelling economic doom. However, if they let yields rise, they abandon their 2% inflation target, and go back to deflation, reducing the incentives to borrow that fuel economic growth.
Why Should You Care?
So why should you care what the central bank of a country thousands of miles away does with its monetary policy? It just so happens that Japan is the second-largest holder of U.S. debt right after the Fed (Figure 14).
Figure 14: Who Owns U.S. Debt?
After the BOJ’s extreme expansionary monetary policy, interest rates in Japan were left near zero or negative. Japanese investors and institutions had to turn to the U.S. for positive yields on safe government bonds, which led to Japan being the primary foreign holder of U.S. debt and has continued to increase their holdings (Figure 15).
Figure 15: Amount Of U.S. Debt Owned By Major Foreign Holders In The Past Two Decades
So what happens if the BOJ chooses to save its currency by letting the rate rise? Well, then yields in Japan will have positive returns again. All those Japanese holders of U.S. debt seeking positive yields overseas could start to pull back their foreign investments and place them in domestic securities. This spells trouble for the U.S. Treasury market, with run-off beginning in the coming months. There is a potential that the two largest buyers of Treasuries, the Fed and Japan, will be exiting (by exiting I really mean fewer inflows from Japan, not a complete exit) the market at the same time. If these two exit, or reduce their buying simultaneously, then a massive void will form in the Treasury market. If no one steps up to fill the void, demand won’t match supply, causing interest rates to move higher.
On the surface, the yen’s devaluation appears to be attributed to the strength of the dollar. However, like an iceberg, below water level is a complex system with potential global repercussions. The yen crashing is a symptom of a more significant systematic problem Japan has been facing for the past four decades. It has left the BOJ with a difficult dilemma to save the yen, with the BOJ having options either resulting in deflation or the yen crashing, drastically increasing import costs and reducing profitability. Both of these situations have the potential to spell doom for the Japanese economy, resulting in a “pick your poison” type situation for the BOJ.