The central Bank of Japan (BOJ) opted to raise interest rates on Tuesday to their highest level in 31 years.
The BOJ is lifting the base rate by 25 basis points to “around 1.0%.” It’s the fifth hike for the central bank since it exited the era of negative rates in March 2024.
The central bank says it is encouraged by the high level of corporate profits as well as improvement in jobs and income. That has supported Japan’s economy despite it being weighed down by higher crude oil prices, in a nation that imports all of its oil.
The bank concluded that the threat of a significant slowdown in the Japanese economy has eased, thanks in large part to government efforts to offset higher energy prices through subsidies and by capping fuel prices at a maximum of ¥170 ($1.06) per liter.
Not Since August 1995
Rates last stood this high in Japan in August 1995, when they were on their way down from the 6.0% rate imposed at the height of Japan’s asset bubble. After the bubble popped, Japan spent the better part of the next three decades contending with deflation, which had a devastating effect on what was the world’s second-largest economy.
China surpassed Japan in 2010 in terms of economic might. China’s economy is now, at $20.9 trillion, approaching five times the size of Japan, at $4.4 trillion.
So in the broader context, it’s positive that the central bank feels Japan’s economy is strong enough that it can withstand higher rates. The central bank has always indicated it would only support rate rises if they are accompanied by wage gains, not just price hikes.
One Dissent on the Vote
I flagged in my last story that it was likely the BOJ would hike on Tuesday. The vote was 7-1, and markets are factoring in a 54% probability of another rate hike in October.
TS Lombard certainly believes an October hike is likely, if there isn’t one even sooner. It notes two big problems for the BOJ:
Japanese Prime Minister Sanae Takaichi is a disciple of the late leader Shinzo Abe and his policies of “Abenomics,” which call for a dovish stance on interest rates, suggesting she may pressure the central bank to hold off on rates as well as appointing BOJ members who share her view
The central bank is shifting to what it considers a hawkish stance — but this is not viewed as particularly hawkish by markets, which have in the past factored in a very slow pace of interest-rate normalization.
We could add a third point of course: interest rates in Japan are still at just 1.0%! It’s a rounding error!
Japan’s Rates Lowest in G7
That’s the lowest among the G7 major economies by some stretch. Consider that rates are at 3.75% in the United Kingdom, at 3.50% to 3.75% in the United States, at 2.40% for the European Union, and at 2.25% in Canada.
The rate of rate rises has been so measured in Japan that the Japanese yen actually weakened when the BOJ made its first rate hike in March 2024 because the language made it clear that further rate increases would be few and far between.
Lombard now predicts that we may see the supremely low Japanese yen turn around. The yen currently trades at ¥160.46 to the U.S. dollar, having weakened in bursts since it last changed hands around its “normal” rate of around ¥110 in September 2021.
Yen Ready to Rally?
The yen has recently struggled to strengthen past ¥140, encountering significant resistance around that level. Japanese authorities have stepped in to protect it when it has crested above ¥160, though those efforts are inevitably expensive and short-lived.
One explanation for the protracted yen weakness is that Japanese institutional investors are keeping money offshore, often in U.S. assets, rather than trying to play a game of “catch the falling knife” by buying Japanese government bonds (JGBs).
Lombard thinks stability in the 10-year JGB would encourage repatriations, which had already started in Q1 before the Iran war began. Stable JGBs “could trigger an acceleration in those flows and support yen appreciation,” Lombard economist Rory Green writes in a note to clients. “Until then, the MoF )(Ministry of Finance) and BOJ will continue to defend the ¥160 level.”
Inflation a Problem Across Asia
Central banks around Asia are contending with inflation, much of it linked to higher fuel prices due to the closure of the Strait of Hormuz and difficulty importing energy from the Persian Gulf.
Inflation had even recently become a problem in Japan. It stood at elevated levels above the central bank’s target of 2.0% from April 2022 until this year. Although it has fallen back to the current level of 1.4%, that’s partly thanks to those government efforts to keep household energy price hikes in check.
Business-to-business transactions have recently been reflecting pass-through costs stemming from the higher cost of oil and energy. So the central bank notes that inflation may soon creep into consumer prices.
Central-Bank Chief Hospitalized
The loan dissention from the rate hike came from newcomer Toichiro Asada, who joined the board on April 1 and says he is concerned about potential shocks to the economy from the conflict in the Middle East. BOJ Governor Kazuo Ueda was himself absent from the deliberations because he has been hospitalized as a result of an infected liver cyst, treatment likely to last two weeks.
Deputy Governor Shinichi Uchida oversaw proceedings in Ueda’s absence. Although higher energy costs are likely to cause a deceleration in Japan’s overall growth, the current negotiations to keep the Strait of Hormuz open indicate that pressure from oil prices will wane. Brent crude has already broken below $80 a barrel, down from a high of $114 last month.
Uchida calls the potential memorandum of understanding between Iran and the United States, due to be signed on Friday if all goes well, a “welcome move.” He believes that “the risk of a sharp deterioration in the economy has diminished. On the other hand, price rises are broadening, and there is a risk that the underlying inflation may deviate from our target.”
A ‘Virtuous Cycle’ Set to Intensify?
The bank projects that the adverse effects of high crude oil prices will wane, and that a “virtuous cycle from income to spending will gradually intensify,” it wrote in its statement about the rate rise. Wages and prices should rise “in interaction with each other,” the central bank noted, with inflation sustaining a level around the 2.0% target for the rest of fiscal 2026 and into 2027.
The BOJ will continue its plan to reduce JGB purchases by ¥200 billion ($1.25 billion) every three months through March 2027, holding purchases steady at ¥2 trillion ($12.5 billion) per month from April 2027 onward. The BOJ holds almost half of all JGBs, which critics say masks their true trading levels. But traders equally worry what would happen to the market if the central bank suddenly and completely withdrew support.
After a very strong Monday, we’ve had a mixed and modest day of trade in Asia on Tuesday. The S&P Pan Asia Broad Market Index almost flat, with a 0.3% rise in early Wall Street trade. Markets in East Asia were generally slightly lower, offset by gains in Southeast Asia.
In Japan, the blue-chip Nikkei 225 eked out a 0.1% rise, although the broad-market Topix dipped 0.2%. Both markets are near all-time highs, with today’s Nikkei close at 69,404.5 its highest on record. The Topix is just off its record close of 3,999.6 set on Monday.
Unhedged Japan Assets the Way to Go
If Lombard is right about the turnaround in the yen, it once again makes the case for holding unhedged positions in Japanese equities. I made this point at the end of April, and it still stands.
U.S. equity investors can select the unhedged U.S.-listed exchange-traded funds (ETFs) investing into Japan.
Chief among those are the large-cap-oriented iShares MSCI Japan ETF (EWJ), the low-fee Franklin FTSE Japan ETF (FLJP), and the JP Morgan BetaBuilders Japan ETF (BBJP), which also has lower fees than EWJ.
Investors more interested in domestic Japan names can look to the WisdomTree Japan SmallCap Dividend Fund (DFJ), the unhedged version of that fund to the DXJS hedged version.
For a direct currency play, investors can consider the Invesco Currencyshares Japanese Yen Trust (FXY). It would profit if the yen gains ground, likely if Japanese rates continue to rise.
AloJapan.com