Investing In Japan Just Got A Lot More Interesting

Investing In Japan Just Got A Lot More Interesting
Russell Burns

about 1 year ago4 mins

  • The Bank of Japan surprised the market with a change to its long-standing policy, doubling the trading band around 10-year yields to +/- 0.50% from +/- 0.25%.

  • The country had held its interest rates at zero for two decades, as it battled against deflation. Now, it’s got a new battle.

  • The Japanese yen strengthened on the central bank’s announcement, and could strengthen further if the Bank of Japan announces additional adjustments to its rigid monetary policy.

The Bank of Japan surprised the market with a change to its long-standing policy, doubling the trading band around 10-year yields to +/- 0.50% from +/- 0.25%.

The country had held its interest rates at zero for two decades, as it battled against deflation. Now, it’s got a new battle.

The Japanese yen strengthened on the central bank’s announcement, and could strengthen further if the Bank of Japan announces additional adjustments to its rigid monetary policy.

Japan is looking more and more interesting. For two decades, it’s been doing the same thing – keeping interest rates at zero in its seemingly never-ending battle against deflation. But, as a surprising move from the Bank of Japan (BoJ) Tuesday morning very clearly demonstrates, the picture is beginning to change. Here’s how you could take advantage…

What’s changed?

The BoJ stunned investors Tuesday, announcing a change to its long-standing bond yield control policy, which it’s been using to restrain how high Japan’s 10-year bond yields can move. The change doubles the width of the band around zero – allowing yields to move as high as 0.5% (and theoretically as low as -0.5%), from the previous +/-0.25%.

And that’s actually huge. While bond yields have moved sharply higher in other advanced economies this year, they’ve been at a standstill forever in Japan: the BoJ moved interest rates to zero in February of 1999. And the BoJ has insisted, as recently as last week, on the importance of maintaining the tighter band, which allows the government to borrow cheaply and spend freely, to stimulate the economy. The move, which effectively raises rates for the country, comes as it grapples with its first bout of inflation in almost 23 years.

What does it mean?

Inflation in Japan (white line) reached a high of 3.7% in October, compared to the year-earlier period, well above the BoJ’s 2% target. Meanwhile, the core measure of inflation, which excludes the more volatile food and energy prices (orange line), was at 2.5% in October, compared to the year before, and is expected to increase to 2.8% in November.

Japan Nationwide Consumer Price Index, all items, in white, and excluding food and energy, in orange. Source: Bloomberg.
Japan Nationwide Consumer Price Index, all items, in white, and excluding food and energy, in orange. Source: Bloomberg.

Japan’s inflation is still much milder than the 9.1% pace seen earlier this year in the US, and the 10.6% seen in Europe, who have both already embarked on rate-hiking cycles to stamp down their sky-high inflation. Nonetheless, for a country that has long had minimal inflation, the current increase has been a bit of a shocker.

Tuesday’s move is being seen by some as the first step in a long walk toward “less dovish” policy – in other words, the kind with higher interest rates – for Japan’s central bank. BoJ’s chief Haruhiko Kuroda has said the move isn’t meant to mark a step toward higher rates and believes that the yield curve control, albeit with a wider range, is sustainable over the long run.

However, recent reports suggest that Prime Minister Fumio Kishida may seek to revise a decade-old agreement that requires the central bank to hit a 2% inflation target “at the earliest possible time”. Although denied by officials, this follows other reports that officials were weighing the possibility of a policy review in 2023. The old adage “no smoke without fire” would tell you something’s going to change.

For now, the BoJ’s move to widen the band looks like it is laying the foundation for a possible rate hike in 2023. And there could be a more substantial change of policy ahead, with the current Bank of Japan governor set to leave his post in April.

What’s the takeaway for markets?

On Tuesday, following the BoJ’s announcement, Japan’s 10-year yield shot toward the higher end of the newly fattened band, to 0.44%, and ended the trading day at 0.4%. It gave Japan’s currency a boost too: with the yen strengthening about 3% to trade at roughly 133 to the dollar.

That could take some pressure off the BoJ as well. See, ever since the US Federal Reserve (the Fed) began raising interest rates last March, the gap between bond yields in the US and Japan has become wider and wider, and that’s driven the dollar higher and the yen sharply lower, as I explained here. The weaker yen may have been a boon for Japanese companies with huge overseas operations, since it raises the value of the money they make abroad, but it’s been a burden for households and domestically focused firms, because it increases the cost of imported goods. That’s why the central bank eventually took the unusual step of intervening in the currency market – buying yen to increase its value – in both September and October. It was the first intervention by the BoJ since March 2011.

What's the opportunity then?

Things have seemed to be turning in the yen’s favor lately, with the BoJ’s recent yen-buying moves, the greenback broadly falling alongside inflation and rate-hike expectations, and this week with the new doubling of the 10-year bond yield’s trading band. And future policy changes could see the yen strengthen even more. The easiest way to take advantage is to “get long” the yen. You can trade currencies directly with your broker or you could consider buying a currency-focused ETF, like the Invesco CurrencyShares Japan ETF (ticker: FXY; expense ratio: 0.4%).

Invesco CurrencyShares Japan ETF. Source: Bloomberg
Invesco CurrencyShares Japan ETF. Source: Bloomberg

Or, you could consider investing in Japanese banks. With interest rates near zero for more than 20 years, their returns have been terrible, despite the fact that their valuations have often looked cheap. But now trading at a 9x price-to-earnings ratio, 0.5x price-to-book ratio, and with a 4% dividend yield (plus share buybacks), Mitsubishi UFJ Financial (MUFG US), the largest of the Japanese banks, could turn out to be a good holiday present for your portfolio.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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