The yen has been a relatively popular topic of discussion lately. Much is being said about the yen carry trade (where firms borrow money at near-zero rates in Japan and invest it into higher rate markets) which is estimated at $4 trillion. The magnitude of this carry trade means that movement in the yen have significant impacts in global markets, and traders have been especially worried about the unwinding of the yen carry. In fact, some believe that the recent rate hike by the Bank of Japan (BOJ) was a significant contributor to the temporary market meltdown in early August.
Despite recent strengthening, the yen has been in a free-fall for much of the recent past. Shorting the yen is one of the most popular and successful currency bets on Wall Street and it was trading at a 34-year low in July. The reasons for its prolonged weakness are largely structural. Japan’s benchmark interest rate is around 0.25% compared to the 5.25% – 5.5% US benchmark Fed Funds rate and the 4.25% benchmark rate in Europe. These vast rate disparities have severely restricted the inflow of funds into Japan and accelerated the outflow of funds from Japan to foreign markets. Resilient macroeconomic growth, especially in the US, has added further downward pressure to the yen. While the recent rate hike caused consternation in global markets – and may have been politically motivated – I foresee that significant changes to the Japanese monetary environment will lead to upward pressure on the yen and sustainable appreciation. Bullish long-term positions on the yen are rare – for good reason – but I believe the yen should have room to further appreciate for the following reasons:
- Tightening interest rate spread & Japanese inflation
- Economic growth & increased inflows
- Government support for the yen & limited room to fall
There are a variety of ETFs that track the Japanese yen, but one of the most popular ones is Invesco CurrencyShares Japanese Yen Trust (NYSEARCA:FXY), which is designed to be long on the Japanese yen against the US dollar. The main advantage of FXY is that it is a pure currency ETF, and doesn’t involve swaps or derivatives, unlike other ETFs. It is also one of the most liquid ETFs tracking the yen, has a low expense ratio, and Invesco, its issuer, is the fourth largest ETF provider worldwide.
Shrinking Interest Rate Spread
The yen is heavily dependent on benchmark rates in other countries, especially the US. The Fed’s moves are extremely important for Japan: the yen’s collapse was driven by the rate increases in the US. Andrew Brenner, head of international fixed income at NatAlliance Securities, explains that, “It’s all about the Fed. Higher for longer is keeping the front end of rates very high, drawing money into the US and keeping the dollar strong.”
The strong dollar contributed to the weakness in the yen, but the dollar is expected to weaken due to rate cuts. The past couple of job reports have come in under expectations, and there’s a growing chorus of voices pointing towards a September rate cut for the Fed. The first rate cut is widely viewed as a harbinger of further rate cuts; traders expect the federal funds rate to reach 4-4.25% after the December 18th Federal Open Markets Committee Meeting (FOMC).
FXY is particularly attractive in this instance since it’s long on the yen against the dollar. Thus, a weakening dollar due to interest rate cuts will further boost the performance of the ETF.
The rate gap between Japan and the US is expected to further shrink with rate increases by the BOJ. In fact, Bloomberg reports that “among the 23 of the world’s top central banks featured in Bloomberg’s quarterly guide, only the Bank of Japan won’t end up lowering borrowing costs within the next 18 months. Most are already set to do so this year.” Economists expect that the BOJ is currently in a rate hiking cycle that will bring its benchmark rate to somewhere around 0.5-1.0%.
The main driver for interest rates in Japan, as in the US, is achieving a 2% inflation rate (albeit the BOJ wants inflation to increase while the Fed wants it to decrease). Japan has long struggled with prolonged periods of deflation and the BOJ has repeatedly tried to implement policies to boost inflation to achieve their 2% target.
Their past efforts have mostly failed, but Japan has recently surpassed its goal of 2% inflation and believes that sustainable 2% inflation is “in sight”. Inflation has been driven by a weak yen, easy monetary policy, and – importantly – wage growth. Japanese wage negotiations are rather unique. In the spring, “shunto” negotiations start where enterprise unions negotiate salary adjustments with their employers. The wage hikes negotiated across Japan in 2023 were the highest it’s ever been in 30 years but were then quickly eclipsed by an even bigger hike in 2024.
Inflation is a new phenomenon in Japan and it’s difficult to drive home just how rare of a phenomenon this is in Japan. Raising prices is such a foreign notion for Japanese shop owners that many Japanese executives are going to classes to learn how to raise prices (if only price increases were as rare in the US).
The Japanese Economy is Looking a Lot More Attractive
The Japanese economy has been in a dangerous period of stagnation over the last thirty years, what some call its “lost decades”. The Nikkei 225 (a benchmark index) only recently crossed its 1989 high and, adjusting for inflation, the Japanese stock market is lower than it was in 1989.
From 1991 to 2003, the Japanese economy only by 1.14% annually, a much lower rate than other industrial nations. The average growth rate from 2000-2010 was 1%.
Some of the statistics surrounding Japanese equity markets are incredible: around half of Japan’s listed companies trade under book value, and in 2024 share buybacks by Apple alone were nearly double the cumulative amount of all share buybacks by Japanese companies.
But, once again, things seem to be different this time. The Nikkei 225 gained nearly 30% in 2023 and is up around 15% in 2024 so far, arguably due to lasting corporate reforms and increased foreign investment. The Tokyo Stock Exchange (TSE) has set a number of changes into motion that are designed to increase the attractiveness of Japanese companies.
The TSE has encouraged management buyout growth and share buyouts. While share buyouts are still incredibly low, they are the highest it’s ever been in history. There have also been several noteworthy developments in the Japanese corporate landscape. There’s been a surge in Management Buyout (MBO) activities, with companies like Taisho Pharmaceutical, Benesse, Outsourcing, Dai-ichi Life, and Nidec actively engaged in such endeavors. These MBOs signify a strategic shift in ownership structures and operational control within these firms.
Furthermore, there’s been a concerted effort to reduce cross-shareholdings, particularly led by prominent entities like the Toyota group. Toyota’s decision to divest its stakes in key tier-one OEM supplier Denso and relinquish its 5% stake in Harmonic Drive Systems is a significant move towards streamlining its portfolio and enhancing transparency. Concurrently, Toyota-affiliated bearing manufacturer JTEKT’s plan to eliminate cross-shareholdings entirely underscores a broader trend toward optimizing capital allocation.
About half of the Japanese firms are actively considering business reviews or restructuring initiatives aimed at elevating corporate value. Japanese businesses are also sitting on a $1.5 trillion pile of cash and many plan to use that for further dividends and buybacks.
The Japanese government has also unveiled a revamped savings plan designed to entice investors to spend more in equities – though it’s worth noting that most of the Japanese used the revamped plan to invest in foreign equities. Nevertheless, Japanese households are sitting on about $7 trillion in cash, which may they further deploy into the equity markets.
Japanese equity markets are important to the yen because an inflow of investments in Japan will increase the demand for the yen. The strength of the equity markets has already increased such inflows. Japanese stocks accumulated about 6.3 trillion yen ($43.39 billion) worth of foreign inflows on a net basis last year, the biggest amount since at least 2014, according to data from the country’s stock exchanges.
Of course, the stock market isn’t the economy, and Japan was nearly in a technical recession earlier this year. Nevertheless, there have been concrete signs that the environment in Japan is changing. Foreign inflows are increasing – Warren Buffett bought stakes in the Japanese trading firms after all – and continual foreign investment will benefit the yen. More importantly, it perhaps shows that the lost decades are definitively behind Japan and this is a new era – after all, people are raising prices for the first time in their entire life.
The Yen May Have Already Reached Rock Bottom
The BOJ and government have repeatedly signaled that a strong yen is extremely vital. A strong yen increases its purchasing power and makes debt repayment for foreign-denominated bonds more viable. Traders believe that the BOJ sees the 160 dollar/yen conversion rate as a ‘psychological redline’ where they step in to intervene to prop up the currency. It was recently trading around that 160 threshold but has strengthened to 145 dollar/yen and 160 dollar/yen could be considered as a possible floor for the yen since the markets expect the central bank to intervene to prop up the yen after that level. The BOJ has been extremely active in propping up the yen. The BOJ has spent over $100 billion in repeated interventions to prop up the yen in recent months. The government has also been working on shoring up the strength of the yen. It recently appointed a new currency czar to help prop up the currency. Also, a weak yen makes Japanese goods much more attractive and contributed to an explosion in tourism to Japan, which in turn increases demand for the yen.
Why Should I Buy the Yen?
Simply put, the interest rate differential is closing, and I don’t think there is much room for it to fall further. The Japanese government seems adamant about trying to keep the yen above 160 dollar/yen and, as largest foreign holder of US treasury bonds, they definitely have enough firepower to keep buying the yen.
Furthermore, the macroeconomic tides are shifting, and the new environment seems like it’s going to be a lot more conducive to the yen. Rates worldwide are expected to decrease while the benchmark rate in Japan – buoyed by strong inflation for the first time in 34 years – is expected to increase. Japan has fundamentally revamped much of its corporate structure, which has led to record inflows of foreign capital into its equity markets. The revamped savings system in Japan may also help stem the outflows of capital while continuing to attract increased inflows.
Risks
The forex market is inherently complex and subject to unpredictable machinations of the global economy. In Japan specifically, there is political risk. The incumbent prime minister, Fumio Kishida, has announced that he will not be seeking re-election, prompting a scramble within his LDP party to find a replacement. The candidate the LDP party puts forth is widely expected to become the prime minister. The political situation undoubtedly has the potential to influence economic policy – some suspect that the latest rate hike by the BOJ was influenced by political pressure. Political uncertainty could make it more difficult to predict the movement of the yen. Nevertheless, many in Japan are feeling the pinch of higher inflation and several of the leading contenders, including Shigeru Ishiba, Kono Taro, and Toshimitsu Motegi have advocated for more interest rate hikes.
The macroeconomy in the US has been unpredictable over the last couple of years – the Fed infamously believed inflation to be transitory in 2021. Surprisingly strong jobs reports or sudden surges in inflation could keep US interest rates higher for longer. The early August market meltdown after the BOJ raised rates also showcased how the US and Japanese markets have become increasingly entangled due to the yen carry trade, which could have unpredictable effects on the yen. This makes liquidity in an ETF extremely valuable, which positions FXY as a better investment than many of the other yen-based ETFs since FXY is more liquid.
Nevertheless, I believe the fundamentals of the yen are strong and it’s just gotten past bottoming. The interest rate gap is closing, the yen carry is unwinding, and the government has made the strong yen a priority.
Conclusion
As I said at the beginning of this piece, I’m slightly nervous to be betting on Japan. Historically, over the last 35 years, that hasn’t been a good move. I’ve made many successful bets against the yen and, to say the least, it feels a little disquieting to be on the other side for once. But the macroeconomic situation in Japan has been changing and the changes have been dramatic. It ended the negative interest rate experiment, inflation has shown up once again, equities have finally risen, and corporate governance has finally been revamped.
FXY is one of the most popular ETFs tracking the yen and, since it’s effectively short on the dollar, it also stands to benefit from a weakening dollar.
I think the yen is going to appreciate. It seems like the land of the rising sun is finally rising again.
Yuji Sakai
