TIME TO PAY ATTENTION TO JAPAN: The Japanese Carry Trade is Not To Be Fooled With!

To address the significance of what is unfolding in Japan and what it potentially means to America, we need to examine the following:

1. 1. How Important is The Japanese Carry Trade to America and the World?
   2. Key Components to the Japanese Carry Trade
   3. Current Developments in Japan
   4. What these Developments Mean?
   5. Ramifications to Your Investment Strategy?

THE JAPANESE CARRY TRADE – The Last Man Standing For America?

IMPORTANCE OF JAPAN BUYING US DEBT

With the emergence of BRICS-11 and gaining momentum of De-Dollarization, Japan has become central to the US funding its growing government debt. For the last decade China and Japan have been the dominant offical players in the purchase of US Debt. China has been steadily selling US Debt (See chart right in black), Russia has sold all US debt holdings, and other US sanctioned countries have sold their US debt or minmally stopped buying more. That has left the US dependent on Japan to not simply maintain its current holdings (as they roll-over), but substantially increase their holdings.

IMPORTANCE OF JAPANESE CARRY TRADE

The Bank of Japan (BOJ)’s offical buying of US debt is reflected in the table below. What is not clearly evident in the chart is the impact of the Japanese Carry Trade in also purchasing US debt. Global banks, Financial Institutions, Pension Plans, Insurance Companies, Hedge Funds and Large Fund Managers world wide engage in borrowing at near zero interest in Japan, buying US debt (currently yielding 4.3% on the US 10Y) and profit the difference after any currency hedging costs. It is quite literally like printing money. These transactions are often held in accounts in the Grand Caymans and Luxemberg. ANY CHANGE TO THIS FLOW AND THE US DEBT PYRAMID COLLAPSES!!

WHAT DOES ALL THIS POSSIBLY MEAN?

THE JAPANESE CARRY TRADE

GENERIC CARRY TRADE

• • For a Carry Trade to work there must be an interest rate differential between two countries sufficent to motivate institutions to capture that differential.
  • There also must be an incentive for lenders in the low interest bearing nation to want to lend. The motivation here is usually to protect against currency devaluation or capture that expected devaluation.
  • Both of these requirements have been abundant in Japan for decades and assisted in funding the US as it slowly became a country consuming more than it produced.
  • The borrower has added incentive to borrow if the lending country’s currency is devaluing, because they will pay the borrowing back at a lower currency value since the debt was taken out in the local currency.
  • However, the borrowing country can experience the exposure to an appreciating currency in the country to which the carry is invested. Currency Hedging is therefore required which has costs that must be netted against the Carry gains.
  • As simple as this seem, it requires an institutional framework to execute effectively cross border as rates, currencies and taxations changes.

SITUATIONAL ANALYSIS

JAPAN IS DIFFERENT IN THREE MAJOR REGARDS

1. 1. Politicians (Ministry of Finance) control interest rates in Japan, not the central bank (BOJ).
   2. Japan is an island and as such is dependent on Imports for almost everything. It makes a living exporting value add to the materials and components it initially imported (i.e. Cars and Electronics).
   3. Mrs. Watanabe

• • • Mrs. Watanabe is a collective term for thousands of Japanese housewives who invest while at home. The term is a metaphor for Japan’s housewife yen speculators. It entered the vernacular in 1997 when The Economist wrote about individual retail investors in Japan. 
    • Mrs. Watanabe is a common Japanese surname. The original meaning of the name was occupational, referring to the “ferrymen’s guild”. It is one of the ten most common surnames, especially in eastern Japan. 
    • Mrs. Watanabe is a carry trader who makes a profit by selling the low interest JPY. 
    • In 2022, Mrs. Watanabe broke retail FX trading records.
    • The Carry Trade is Carried out by Foreigners but Financed by Low lending rates offered by willing Japanese Banks, Investors & BOJ.

JAPANESE CARRY TRADE:

• • The massive Japanese Carry Trade requires higher yielding foreign bond yields, while their rising currency relative to the Yen means high profits are repatriated into low cost yen. Those profits, if spent on consumption by private lenders (Mrs Wantanabe), must absorb inflation while lending institutions must use local currency hedges to capture the small lending yields.
  • If however they are only lending nation investments, they will be pledged as collateral and investments taken out in high yielding cash overseas (like US T-Bills, Money Market Funds et al.).
  • The process and rewards are different for Japanese Private Investors, Japanese Banks, The BOJ and Foreign Lenders. All come with their own levels of complexity.

BOJ CAN’T RAISE RATES SIGNIFICANTLY BECAUSE:

• • The Japanese economy is now built on low rates. Rate increase must be gradual, but rates have been a US driven de-stabilizing shock.
  • Though Japan recently raised the YCC upper band modestly, it has become problematic to sustain.
  • Higher interest rates are expected to stil be a few years away, because the Bank of Japan needs to manage any risk to the economy from sudden hikes. 

PROBLEM:

• • Policy of Sustained Low Rates & YCC initiated to counter deflation
  • Japan’s central bank, the Bank of Japan (BOJ), has kept its benchmark rate at -0.1% since 2016. It is the only nation still maintaining negative rates.
  • Low rates have made Japanese Yields less attractive than American rates and is thereby weakening the Yen versus Dollar and other currencies.
  • Yen is at a three decade low versus the dollar, which is making imports (as an import nation) more expensive and pushing inflation up. This places more pressures on rates needing to be higher.
  • Japan’s debt is owned primarily by itself and maintains a possible trade balance.
  • It is currently expected that the US Dollar may reach 170 if Japanese rates continue to be maintained at current low levels.

PERCEPTION: WHY THE BOJ HAS NOT RAISED INTEREST RATES IS BECAUSE:

1. 1. Japan’s government is heavily indebted. A rate increase could make it more difficult for Japan to service its debt.
   2. Tightening monetary policy prematurely could put Japan’s goal of attaining stable 2% inflation at risk.
   3. The government, not the central bank, has jurisdiction over exchange-rate policy.
   4. The BOJ forecasts lower future inflation.

The BOJ has recently taken steps toward allowing interest rates to rise. Japan’s Ministry of Finance has stated it will raise its assumed long-term interest rate to 1.5% for the fiscal 2024/25 year. 

“SIGNALS” OUT OF JAPAN

To get a clearer perspective of what the current Japanese developments potentially mean, it would be valuable to read the following studies for current context and many excellent charts.

• • 09/07/23: Will markets force the BOJ to finally abandon negative rates? With a resilient US facing higher rates for longer, the weak yen could lead to a big change in Japan.
  • 08/10/23: Japan’s inflation revolution Nominal GDP, wages and corporate revenues are growing at the fastest rate in 30 years.
  • 07/11/23: Forward guidance on… wages? Japan’s companies promise higher pay and consider AI – as stocks and GDP forecasts perk up As Japanese demographics suddenly turn inflationary, companies are scrambling for solutions.
  • 04/05/23: As Ueda takes the helm of the Bank of Japan, do record wage hikes finally portend “good inflation?” There are implications for major companies, yield curve control and the central bank’s swollen balance sheet.
  • 01/23/23: The Kuroda Code: No virtuous wage-price spiral in Japan Bank of Japan Governor Kuroda wants a “virtuous wage-price spiral” to push inflation to his target.

BANK OF JAPAN GOVERNOR KAZUO UEDA stirred the markets when he somewhat surprisingly told a Yomiuri newspaper interview last Saturday the BOJ could get enough data by year-end to judge whether conditions are in place to raise short-term interest rates.

Reuters is streaming reporting on this development:

• • Bank of Japan Governor Kazuo Ueda said the central bank could end its negative interest rate policy when achievement of its 2% inflation target is in sight, a Yomiuri newspaper reported. This signaled possible interest rate hikes.
  • The central bank could have enough data by year-end to determine whether it can end negative rates, Ueda told the paper in an interview on Wednesday.
  • “Once we’re convinced Japan will see sustained rises in inflation accompanied by wage growth, there are various options we can take,” Ueda was quoted as saying.
  • “If we judge that Japan can achieve its inflation target even after ending negative rates, we’ll do so,” he added.
  • The BOJ currently guides short-term interest rates at -0.1% under its negative rate policy. It also caps the 10-year government bond yield around zero as part of efforts to reflate the economy and sustainably achieve its target.
  • With inflation exceeding its 2% target for more than a year, markets have been rife with speculation the BOJ will soon start raising interest rates.
  • But Ueda has stressed the need to maintain ultra-loose policy until the BOJ is convinced inflation will sustainably stay around 2% backed by solid demand and wage growth.
  • Ueda repeated the stance in the interview, saying the BOJ will “patiently” maintain ultra-loose policy for the time being.
  • “While Japan is showing budding positive signs, achievement of our target isn’t in sight yet,” he told the interviewer.
  • The BOJ will not turn a blind eye to the risk of inflation exceeding expectations, Ueda said, adding wage rises are beginning to push up service prices.
  • The key is whether wages will keep rising next year, Ueda said. “We can’t rule out the possibility we’ll get enough information and data by year-end,” he was quoted as saying on the timing for ending negative rates.
  • Under a negative rate policy, banks and other financial institutions are required to pay interest for parking excess cash — beyond what authorities say they must keep on hand for safety reasons — with the central bank.

Bank of Japan policymakers have been increasingly talking up the need to shift away from the massive monetary stimulus of the past decade, even as growing global risks heighten concerns about a fragile economic recovery. A series of hawkish comments by BOJ speakers in recent weeks suggest the bank is preparing markets for an eventual policy change amid growing price pressures in deflation-prone Japan. Even dovish members of the BOJ board have expressed an openness to talk about a long-awaited exit from the extremely accommodative policy of former governor Haruhiko Kuroda, acknowledging changes in conditions may warrant a tweak in monetary settings.

Ueda’s remarks, which pushed up the yen and bond yields on Monday, followed those of BOJ board member Naoki Tamura last month that suggested the bank could safely hike short-term rates without hurting the economy.

• • “Even if the BOJ were to end negative rates, it won’t be scaling back monetary easing as long as it can keep interest rates low,” said Tamura, a former commercial bank executive.
  • The commentary contrasts in tone to the pro-growth posture adopted under Kuroda, an advocate of aggressive monetary easing to shock Japan out of its deflationary mindset.
  • It also suggests the BOJ under Ueda will be more inclined to prioritize unwinding the Kuroda-era policy framework, which has been blamed for distorting bond markets and crushing bank margin.
  • “The BOJ will proclaim that Japan has achieved 2% inflation and end negative rates in April,” said Mari Iwashita, chief market economist at Daiwa Securities and a veteran BOJ watcher.
  • To be sure, the BOJ is in no rush to phase out stimulus until there is enough data suggesting the economy can withstand the impact of weakening global demand and allow firms to keep hiking wages, say three sources familiar with its thinking.
  • But growing signs of change in Japan’s deflation-prone economy are making policymakers more open to discussing the hurdles for an exit, a sign they see decision-time approaching.
  • Inflation has exceeded the BOJ’s 2% target for more than a year as companies pass on higher costs to households. Firms also offered the largest pay hikes in three decades. Even doves in the nine-member board have noted these changes.
  • “I believe Japan’s economy is finally seeing early signs of achieving the BOJ’s 2% inflation target,” said Hajime Takata, one such board member.
  • “We need to patiently maintain the current massive monetary stimulus. At the same time, we need to respond nimbly against uncertainties as we’re seeing early signs of a positive cycle emerge” between wages and inflation, he said.
  • Another board member, Junko Nakagawa, laid out the conditions for ending negative rates, notably a continued improvement in household confidence.
  • “When we see many people share prospects that wages will keep rising, we may be able to exit (negative rates).”

NO PRE-SET TIMING

• • Since taking the helm in April, Ueda has moved steadily toward phasing out stimulus. The BOJ tweaked policy in July to allow long-term rates to rise more reflecting higher inflation.
  • The next step would be to ditch or hike a 0% target set for the 10-year bond yield, and raise short-term rates from -0.1%.
  • Policymakers’ recent remarks suggest the BOJ could act sooner than markets expect. A majority of analysts polled by Reuters in August saw the BOJ scaling back stimulus only in a year’s time. Less than half expect negative rates to end in 2024.
  • There seems to be no consensus within the BOJ board however on when or how the bank would dismantle Kuroda’s complex policy framework.
  • Ueda said the BOJ could end negative rates if it believed that inflation would sustainably hold above the target.
  • His deputy Shinichi Uchida appeared to set a higher bar for ending negative rates, saying last month there was “still a long way to go” before conditions were met.
  • Next year’s wage outlook remains key.
  • Japanese firms traditionally kick off their spring “shunto” wage negotiations with unions in March. But the BOJ could get information before those talks through its regional branch offices and comments from corporate executives on the wage outlook, the sources said.
  • The global outlook would also be crucial with a downturn in the U.S. and Chinese economies hurting manufacturers and discouraging pay hikes, the sources said.
  • “There’s so much uncertainty on the outlook for wages and Japan’s economy,” one of the sources said. “The BOJ probably doesn’t have a pre-set timing in mind on when it can take the next step.”

Subsequentially a Nikkei article stated:

• There is a sense at the BoJ that December is too soon to end negative rates and although the government is keen on moves that could support the weak Yen, December is a politically difficult time and a January decision appears to be a more realistic scenario.

More Developments:

• • Japanese PM Kishida said he will ensure the end of deflation and will take steps to attract investments by the private and public sectors sized around JPY 150tln. Kishida also said he will instruct the cabinet to compile pillars of a new economic package by the end of this month, while he cannot say when the government will decide on the start of the tax hike for the defense budget.
  • Japan’s new economy minister Shindo said they will mobilize all possible policy measures to support the economy and will consider bold measures to ease the pain of price hikes, according to Reuters.

LARGE DIFFERENTIALS ARE SUPPORTIVE OF A JAPANESE CARRY TRADE

(WITH A WEAKENING YEN – See Current Current Market Perspective)

INVESTMENT PERSPECTIVES

Our analysis suggests the following for consideration:

1. 1. SHORT YEN – Through Year End 2023
   2. LONG HIGH QUALITY JAPANESE EQUITIES – Short-to-Intermediate Term
   3. LONG US TREASURY NOTES & BONDS – Intermediate Term
   4. SHORT US DOLLAR – Short-to-Intermediate Term

See this week’s Current Market Perspective for Technical Analysis and Charts for Japan