On Friday, the Bank of Japan and the Japanese government issued a rare joint statement indicating that they may intervene if Yen weakness persists. So far, the fallout from the weaker yen has been minimal for broader financial markets, but that could change if the selloff gathers momentum.
Below are key questions about the implications of the lower yen for the Japanese economy and international markets:
Why is the yen weak?
The yen, the world’s third most traded currency, is now close to 134 per dollar after starting 2022 at 115. With the dollar up 16% year-to-date, the yen is on course to experience its largest annual decline since 2013.
This weakness stems mainly from widening interest rate differentials between Japan and the rest of the world. As the rest of the world, led by the US Federal Reserve, aggressively hikes rates to rein in runaway inflation, the BOJ has doubled down on its easy policy stance.
The spread between Japanese 10-year government bond yields and those of the United States is 279 basis points, a high of nearly 3.5 years, while the spread with German yields is at its highest level for 8 years.
Will the authorities intervene?
They say they could do it. On Friday, Japan’s government and central bank said they were concerned about the recent steep falls in the strongest warning yet that Tokyo could step in.
The yen has quickly moved away from two-decade lows, but not everyone is convinced that real intervention is likely. Given the economy’s reliance on exports, Japan has historically focused on stopping strong yen gains and taking a hands-off approach to yen weakness, which is more difficult because buying yen requires Japan to draw on limited foreign reserves.
The last time Japan stepped in to support its currency was in 1998, when the Asian financial crisis triggered rapid capital outflows from the region. Before that, Tokyo had intervened to counter the fall of the yen in 1991-1992.
Foreign exchange interventions are costly and could easily fail given the difficulty of influencing the value of the yen in global foreign exchange markets.
What can stop the decline?
A marked improvement in growth prospects with the reopening of the country’s borders after the COVID operation and a rise in inflation could change the BOJ’s dovish attitude.
In April, core consumer prices in Japan rose 2.1% from a year earlier, beating the BOJ’s inflation target of 2% for the first time in seven years. “The yen’s slide could halt if the Bank of Japan changes course and becomes hawkish,” said Francesca Fornasari, head of currency solutions at Insight Investments.
Any signs of rate caps outside of Japan could also spark a rally. But there is no sign of it, with US rates expected to peak at 3.5% in mid-2023, according to futures markets.
Does a weaker yen stimulate the economy?
The yen returned to a seven-year low against the Chinese yuan and hit new multi-year lows against the Korean won and Taiwanese dollar, which should ease Japan’s growing trade deficit.
Some, like John Vail, chief global strategist at Nikko Asset Management, believe the weak currency is crucial for the Japanese economy to maintain its competitiveness as a safe source of supply chain diversification.
The decline of the yen also strengthens the attractiveness of the Japanese stock market to foreign investors who consider it undervalued compared to European and American markets. Japanese stocks have outperformed their rivals in 2022, although they are still falling as investors around the world dump riskier assets.
What does this mean for the foreign exchange markets?
The yen has long been the currency of choice for investors who engage in so-called carry trades, which involve borrowing in a low-yielding currency like the yen to invest in higher-yielding currencies like the US or Canadian dollar. A strategy of borrowing in yen and investing in an equal basket of US, Australian and Canadian dollars would have returned 13% so far in 2022, according to Refinitiv data.
But the speed of the yen’s fall and questions about policymakers’ intervention are fueling investor unease, especially with short bets against the yen nearing six-month highs. Further volatility and weakness could hurt its appeal as a funding currency.
All currencies gain in value against the Yen, with the dollar gaining more than 15% against the Japanese currency since January 1, 2022
What about domestic investors?
The weakness of the yen puts the Japanese investors in the embarrassment.
Yields are high and rising, which makes foreign bonds much more attractive. But it also means that the cost of hedging currency risk increases. Thus, Japanese investors can often only take advantage of higher yields if they buy unhedged foreign bonds.
But with the yen at such low levels, it is difficult for investors to bear such currency risk, such as an appreciation of the yen. Even a modest return to 115-120, where we were four months ago, would wipe out years of yield advantage.