The Nikkei 225, the leading index for the Japanese Tokyo stock exchange, has surged to all-time highs in recent weeks, having strengthened by almost 20% since the start of the year alone.
The Nikkei’s historic bull run has been fuelled by a weak yen, which has made Japanese assets cheaper for foreign investors, as well as strong company results for the country’s major listed companies.
Japan has also benefited from foreign investors shifting away from Chinese stocks in light of Beijing’s sluggish post-Covid recovery, greater geopolitical tensions between China and the United States, and an ongoing real estate crisis in the country that still threatens to send shockwaves through the economy.
Financiers wishing to retain their exposure to Asian markets while minimising their exposure to a declining Chinese stock market have found a strong alternative in Tokyo.
However, the strong gains posted on the Nikkei could also have ramifications in the world of monetary policy and, in turn, on foreign exchange markets. Indeed, many analysts believe that the Nikkei’s march to record highs provides a “cushion” for the Bank of Japan (BOJ) to raise interest rates.
Hideo Kumano, Chief Economist at the Dai-ichi Life Research Institute in Tokyo, said that the country’s central bank has encouraged the bull run on stock markets in a bid to help the BOJ pivot away from its ultra-loose monetary policy. “Creating a supportive environment for a policy shift is exactly what BOJ Governor Kazuo Udea has been doing,” he said.
This has partly involved continuing the BOJ’s purchases of exchange-traded funds (ETFs), which has boosted prices on the Nikkei, although there are signs that the central bank could be starting to change this approach.
A stronger Nikkei makes interest rate increases more likely because, put simply, there tends to be an inverse correlation between rates and the stock market. When rates are low, share prices tend to be higher; and when interest rates rise, stock prices trend lower. The Nikkei being at all-time highs therefore gives the BOJ space to raise interest rates and send stock prices lower, but without causing the kind of market rout we have seen engulf China in recent weeks.
Partly because of this, expectations are now growing that the Japanese central bank will finally drop its policy of ultra-loose monetary policy , with rates currently negative at -0.1%. 17% of economists reportedly expect a policy shift when the BOJ meets towards the end of March, and 73% believe the shift will come at the April meeting. The Deputy Governor of the central bank, Shinichi Uchida, further fuelled this belief when he gave a speech earlier this month outlining how a pivot away from the negative rates environment would work in practice.
With inflation in Japan rising from its historic lows, currently standing at 2.5%, this also gives further breathing space for the central bank to tighten monetary policy and raise interest rates. Markets are now entirely convinced that positive interest rates are on their way very shortly in Japan. Earlier in February, one-year Treasury bills produced a positive rate for the first time in almost a decade, with yields on two-year government bonds also hitting 0.15%.
Should this shift come about, as now appears almost certain, this would have ramifications on foreign exchange markets, where the yen is trading at historic lows against the dollar despite the BOJ’s attempts to prop up its value by selling billions of dollars’ worth of reserves.
The large discrepancies in rates between the US and Japan – with the former currently offering rates of up to 5.5% and Tokyo offering negative rates – has encouraged foreign exchange traders to boost their exposure to the dollar and benefit from the higher yields on offer.
While the BOJ has emphasised that any rises in interest rates will be limited, meaning there will still be a large interest rate differential between the dollar and the yen, a move to raise rates will nonetheless indicate to traders that higher yields are available in Tokyo. With the Federal Reserve set to embark on a policy of monetary loosening and lowering of rates, this could further encourage traders to look elsewhere for returns, potentially improving the outlook for currencies such as the yen which have depreciated in recent years.
Policymakers in Tokyo are certainly keen to see a stronger yen, hence their consistent intervention in foreign exchange markets, given the 9.29 trillion yen ($61.6 billion) trade deficit which Japan is running. A weaker yen makes imports priced in dollars more expensive in local terms, meaning higher prices for imported goods.
The yen is currently trading against the dollar at around 150, but on average the market is forecasting that the currency will strengthen to around 135. However, much will depend on the extent to which the central bank raises rates and how far the interest rate differential between the yen and dollar narrows.
Author: Harry Clynch
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