Where's the serenity as BOJ collapses Yen

Attribution: Casia Charlie

Cherry blossom fall masks Yen’s base jump

There’s something funky going on in Japan and it’s not the annual Cherry Blossom season.

Curiously, at the same time as the blossoms started in the South, missiles flew into Ukraine and the Yen started to collapse.

Last week the Yen fell to a 20-year low against the USD, base jumping ~12.5% in just one month.

Oof, that’s a massive move for this kind of asset class, particularly given the often sought safe haven of the Japanese Yen.

Why is this happening?

It’s likely to be a potent mixture of external catalysts in the real economy plus unique factors internal to Japan such as mad monetary policy (MMP) and the almost entirely domestic ownership of its bond market.

The key real economy catalysts include:

1. COVID (post-lockdown demand slingshot, broken supply chains and ‘just in case’ procurement/manufacturing).

2. Russia/Ukraine (supply shocks to raw materials used in Japanese industry and soft commodities for food).

This has created a cyclical inflation slingshot.

And here’s two factors unique to Japan:

1. Domestic ownership of the bond market (almost all Japanese bonds are held domestically with around 50% held by BOJ as a result of Abenomics).

2. YCC (yield curve control, with Bank of Japan (BOJ) doing unlimited money printing/10 year bond buying in order to peg the yield at 0.25% and make borrowing and investing in real economic growth cheap/attractive).

And when you mix those four factors you get a rather unique cocktail of high inflation (impetus to raise interest rates); and on the other hand, the requirement to continue with low interest rates in an attempt to stimulate real economic growth (impetus to lower interest rates). 😣🤔

So far, BOJ has chosen the latter and reinforced its intention to continue YCC. It says it will (artificially) keep the 10 year bond pegged at 0.25%, making financing/refinancing, cheap.

The problem is that it’s not stimulating real economic growth.

And like all quantitative easing (QE) and YCC around the world, it’s a lazy, non-inclusive, socially destructive, and ill-advised alternative to smart fiscal policy.

But here’s the really big issue for Japan.

While other central banks are raising, or talking about raising interest rates, and with short end U.S. treasuries potentially about to go to 0.75% to 1.00%, the spread between Japanese bond and US treasury yields has widened.

This widening spread makes it relatively unattractive to hold Yen and way more attractive to buy higher yielding dollars. And it’s this relative analysis that’s leading the sale of Yen at volume and causing the Yen to collapse.

Could this be a problem?

The question is that with ~95% Japanese bonds held domestically, could this be a problem?

The answer is, it could well be. And the reason is that as the fourth largest importer in the world, Japan imports over A$1.1 trillion each year (close to 20% of GDP) to feed its population and industry. While it’s not a net importer - the cost of imports is skyrocketing and crushing firm and household budgets.

Petroleum products and LNG are its biggest imports, and we all know what’s happening with prices in those categories.

It means that at times like this, oil, gas, food and clothing dependent importers like Japan need a strong currency to ensure they can counteract imported cost push inflation.

But for Japan, YCC is keeping benchmark interest rates low. This weakens the Yen and makes already hyperinflating commodities and inputs way more expensive relative to countries with a currency that’s stronger against the U.S. dollar.

So yes, it’s an ‘at the minute’ problem for prices in Japan. It’s also a window into what MMP and Abenomics can do, and the potential direction for other countries that rely on monetary policy and abandon the fiscal. Put another way, tell me in which industry Japan now leads?

Meanwhile, as BOJ continues to pin yields to 0.25%, spreads will widen, Japanese government bonds will become less attractive to hold, more Japanese will sell government bonds/Yen, and the Yen will continue to deflate. That means capital outflow.

Bizarrely, that might be good for the U.S. in the sense that with the Federal Reserve shrinking its balance sheet and scaling down its purchases, at least there will be another buyer in the market!

But for the Japanese, there’s more pain to come, and so the vicious circle continues.

As a result, the Japanese sovereign has got a massive decision to make – (a) control bond prices in an attempt to generate real economic growth (which has so far failed) and let inflation decimate the economy and capital escape; or (b) let yields rise, stem capital outflows and counteract some imported cost push inflation.

Where to now?

The BOJ recently confirmed it had chosen (a).

We know this because last week Japanese Prime Minister Fumio Kishida foreshadowed an economic support package to help struggling low-income households and small firms, just as its April ‘22 print of inflation revealed a move to 26-month highs.

Relief measures of about 1.5 trillion yen are expected to be part of an extraordinary budget worth 2.7 trillion yen. The package was approved by the ruling coalition last week to soften the impact of energy and food prices. Apparently, details will be announced this week.

This signals a continuation of (a) MMP in an attempt to stimulate real and sustainable economic growth (unlikely) while at the same time dealing out transfer payments to firms and households that are being belted with high prices, and are economically incentivised to move their savings offshore.

We should all keep an eye on this because if it doesn’t stop, the Yen will collapse further and inflation might become hyperinflation. It will also be interesting to see whether a hard asset like bitcoin catches a bid under that scenario.

Another perspective?

But there’s another school of thought that’s at least as likely, and it’s that rates in the rest of the world are unlikely to go (or stay) as high as most people think, and in time will fall instead of rise.

If that’s correct and if the timeline is short-term in nature, that kind of scenario might save Japan because spreads between Japanese government bond yields and treasuries will again narrow as we move back to our 700 year old secular path of decreasing interest rates and money destruction.

Japanese funds would then stay onshore, the two safe haven currencies would recalibrate and less inflation importation would occur.

Most commentators say the eventual outcome will come down to whether inflation is (a) persistent and baked in for the long term, or (b) non-persistent.

I get that, but as usual it does not take competitive response into account. That is, the missing piece is how governments and central banks will choose to respond to these economic and geo-political catalysts – monetary, fiscal, Abenomics, war?

Stay tuned.

Mike

Image: Evgeny Tchebotarev

Next Level Corporate Advisory is a leading M&A and capital markets advisor with a 20 year track record of delivering the highest quality of independent financial advice as well as strategic transactions to help companies of all sizes level-up, in and out of Australia.

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