Yen weakness puts pressure on BoJ to toughen policy

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The yen fell to its lowest level against the dollar since November on Friday, increasing pressure on the Bank of Japan to tighten its ultra-loose monetary policy and support the wobbly currency.

Japan’s currency fell to ¥146.6 per dollar after US Federal Reserve Chairman Jay Powell raised the prospect of further domestic interest rate hikes, potentially widening the huge gap between the costs of borrowing United States and Japan.

Japan has been the only major developed market not to raise interest rates in the past 18 months as the countries face the worst inflation shock in a generation.

Although the country has spent decades battling the threat of deflation, recent signs of economic resilience and domestically driven price increases are raising market expectations that the Bank of Japan will toughen its stance.

“Given the resiliency of the Japanese economy, with the latest services producer prices surprising to the upside, I think there will be more pressure on the Bank of Japan to tighten monetary policy at a faster pace to avoid a depreciation of the yen.” said Tomasz Wieladek, chief European economist at T Rowe Price.

The stress on the currency comes just weeks after the Bank of Japan’s surprise decision to loosen controls on its government bond market, easing a cornerstone of its ultra-loose monetary policy.

In late July, the Bank of Japan said it would tolerate 10-year government bond yields as low as 1 percent, from a previous level of 0.5 percent.

Yields on benchmark Japanese government bonds have risen since then, rising 0.03 percentage point this week to 0.66 percent. Investors expect this trend to continue as long as inflation remains above its 2 percent target.

“We believe that higher inflation will cause the BoJ to adjust its forecasts at its next quarterly monetary policy meeting. . . “This may serve as a prelude to the BoJ declaring victory over deflation and removing control from the yield curve,” said Mark Dowding, chief investment officer at RBC Bluebay Asset Management.

“We would see this push 10-year yields towards 1.25 percent, until then we think yields will continue to rise.”

Investors say rising Japanese yields will accelerate bond sales in other major markets as Japanese investors look for higher yields closer to home.

“As yields rise, large domestic investors have an increasing incentive to repatriate funds, sell foreign bonds and reinvest in Japanese government bonds,” said Christian Abuide, head of asset allocation at Lombard Odier. “The benefit of doing it is as high as it has been in the last decade.”

T Rowe Price’s Wieladek added that there was already a “significant fallout” from the Bank of Japan’s decision in July: “It’s keeping yields globally more resilient and at higher levels than people expected.”

Years of higher yields abroad have made foreign assets more attractive, meaning Japanese investors are some of the biggest bondholders in the United States and Europe. According to Commerzbank research, Japanese investors held more than $2 trillion in long-term foreign debt securities at the end of 2022, with large holdings in the United States, France, the Netherlands and Germany.

A rise in bond yields is expected to accelerate the tendency of Japanese investors to sell foreign bonds, a shift that had already begun due to the rising cost of currency hedging.

Many large Japanese investors, such as insurers, routinely hedge their currency exposure when they buy foreign bonds. Rising interest rates in the rest of the developed world have dramatically raised the cost of doing so, in many cases more than closing the widening yield gap between Japan and other economies.