The Yen effect
The quick takeaway
The Yen has been depreciating significantly against the US Dollar over the past few months. This has caused other currencies, bonds and stocks to fall too, due to the complex interconnected-ness between them.
The above cause and effect is the result of the Bank of Japan’s policies and likely has geopolitical motivations behind it.
It is difficult to predict how long these factors may impact equity markets but knowing and observing them may help in being prepared.
The Bank of Japan’s (BOJ) policy history
The Bank of Japan has been the pioneer of quantitative easing (QE) - a policy tool which it first adopted in the 90s to extricate Japan from a deflation after the 80’s asset bubble burst. However the Yen appreciated for most of the time this policy was in force until 2012. As Japan is a big exporting nation, a stronger Yen made it unviable to produce in Japan at globally competitive rates. Hence, a lot of production was outsourced to China and QE was barely able to reduce the impact of the slowdown within Japan.
In 2012, this policy of a stronger Yen was discarded as Japan sought to revitalize its internal economy post two decades of deflation. This caused a sharp depreciation in the Yen v/s the USD initially. When a big exporter follows such a policy, it effectively exports its deflation globally as competing exporter nations are also forced to devalue their currencies.
However that Yen depreciation did not last for too long as almost every nation was also following QE policies at the time and hence the entire globally currency system settled into some sort of equilibrium post the 2013 taper tantrums.
All of this has exploded again since late 2021 - 2022 onwards.
Yield Curve Control (YCC) by the BOJ from late 2021 onwards
Yield Curve Control (YCC) is a rather extreme form of QE where the central bank buys unlimited amount of bonds to make sure the yield is anchored at a certain level. The BOJ introduced its YCC policy in 2016 keeping the yield on 10 yr Japanese bonds (JGBs) anchored around 0% with a wiggle room of 0.25% around it.
At a time when most central banks were following easy money policies, this made little difference and hence the equilibrium was largely maintained.
However, as the Federal Reserve (FED) has sought to change its ultra easy money policies from late 2021 onwards in response to the inflation threat, things have gotten a lot more complicated.
The impact of BOJ’s YCC on bond and currency markets
With the FED looking to raise rates while the BOJ keeps yields fixed, the gap in bond yields between US treasury bonds (USTs) and JGBs starts widening.
This incentivizes financial market participants to borrow in Yen, convert to USD and deploy in USTs and hedge the USD receivables back into the Yen for a riskless profit (arbitrage).
As everyone rushes to exploit this opportunity, the net impact is two fold
The Yen starts depreciating against the USD
The cost of hedging back into the Yen shoots up
And these two effects have a deep impact on global bond & FX markets
Yen depreciation
Japan competes in exports with Germany (the anchor for the Euro) and the big Asian exporters - China, Korea & Taiwan (the anchors for the Asian currency basket - the Asian Dollar Index - ADXY)
A depreciation in the Yen of this magnitude (~20%) makes Japanese exports significantly cheaper and forces competitive devaluation by other exporters thereby weakening the Euro and the Asian currency basket.
This causes almost all currencies to depreciate against the USD thereby accentuating the effect. As financial market participants typically have most assets denominated in USD, weakening of most currencies will depreciate the value of their overseas holdings and raise hedging costs.
Cost of hedging into Yen
As the cost of hedging back into the Yen surges, the effective yield gap between bonds in the US and Japan narrows significantly or even gets negated. This makes it unviable for Japanese institutions to allocate as much to US bonds thereby removing a large buyer from the market.
The absence of a large pool i.e. Japanese buyers of US bonds causes USTs to fall more, pushing up yields and tightening overall financial conditions.
Higher bond yields is detrimental to assets in general including stocks as the cost of money rises and valuations adjust downwards to reflect that.
The geopolitical motivation - double whammy on China
To analyze the motivation for this policy divergence between two key central banks, one could look at the fallout on China.
A cheaper Yen make Japanese exports more competitive thereby impacting the earnings of Chinese exporters and in turn reducing the USD inflows for China.
This forces China to look at softening the Yuan, which in turn creates problems for overseas investors in Chinese bonds. They are likely to sell and exit the Chinese bond markets thus worsening the situation
As the Yuan is loosely pegged to the USD, the monetary policy of the US is transmitted to China. This causes tighter financial conditions exactly when it also gets hit with issues in exports plus a domestic slowdown.
In short, a potential currency + economic war on China.
Keep in mind that US and Japan are allies, and China is the the key regional threat for Japan.
What does this mean for financial investors
A rising USD and rising US bond yields implies a significant tightening of monetary conditions globally, thereby weakening asset prices everywhere outside the US, as investors try to liquidate holdings.
For the US too, a stronger USD impacts overseas earnings of MNCs - i.e. the largest and best US companies - thus negatively impacting US stock indices.
How long does this economic and currency war go on is anyone’s guess but knowing this can help look for markers
A possible end to the Ukraine war itself
The Bank of Japan blinking on YCC
The Fed reversing its tightening stance or even starting YCC itself
China allowing the Yuan to depreciate significantly
Germany panicking on the impact of a falling EUR causing potential hyperinflation and enforcing a sharp change in ECB policy.
The final word
Our belief always was that Ukraine marked the start of a wider conflict between superpowers (see “Preparing for Wartime economies”).
Such a period is bound to be volatile as motivations for many decisions are often geopolitical. They may involve taking economic pain in the event that it forces the other side to reach breaking point.
The positive outcome of all this for us in India is that we have little choice but to accelerate our own development and reduce external dependencies - all of which can be quite beneficial in the long run for financial investors.