The Bank of Japan's (BoJ) decision to end its negative interest rate policy had been expected by markets for a long time. But the announcement on March 19 did feel like a turning point for one of the best-performing stock markets in recent years; after all, the last time the BoJ raised rates was in 2007, the year Netflix (NFLX) first streamed its content, and MySpace was 65 times more valuable than Facebook (META).
While the rise in interest rates generated a lot of headlines and commentary, markets shrugged and continued the familiar pattern of rising share prices and a falling yen: the main indices rose and the yen rose above 150 against the dollar, a new all-time low.
Despite recent success, Japan's stock market history is peppered with false dawns, so the key question for investors is whether the wins can be sustained. A country rally in one year is often by a country slump the next: China was one of the best-performing world markets in 2020. It has struggled since. My colleague Leslie Norton outlined in a recent article why Japan can have another great year in 2024, but it's all to play for.
Weak Yen, Strong Exports. Will That Change?
A key topic for investors to account for is Japan's weak currency, which makes its exports – think robotics, cars and computer games – much cheaper for foreign buyers.
But investors bearish about Japan expect interest rate hikes to end the era of a weaker yen. That's because a rise in interest rates make a country's currency more appealing to investors, attracting capital flows. US government debt has always been attractive to overseas investors, but with the Federal funds rate at 5.25%, this offers a "risk-free" yield that’s above inflation. My colleague Fernando Luque has looked at this in more detail.
The yen recovery hasn't happened yet – mainly because markets don't think the BoJ is embarking on a tightening cycle that will harmonise Japanese and Western interest rates. For comparison, the cost of borrowing in Japan is between 0% and 0.1%. In the UK it's 5.25%. In the Eurozone it's 4.5%.
Japan's Market and Currency Returns at a Glance
• In local currency, the Morningstar Japan index is up 16% in 2024
• Over five years, the index is 96% higher
• 1989: the last time the Japanese stock markets hit a record high
• March 6, 1987: the USD/JPY fx rate was ¥153. Current level: ¥151
What Are Negative Interest Rates?
Following the boom years of the 1980s, when stock and property markets hit record highs, Japan suffered a number of "lost decades" of low growth and deflation.
Japan's negative interest rate policy was instituted in 2016 in an attempt to "reinflate" the economy. After many years, this now appears to have worked, because the domestic economy has some modest inflation, helped by the first pay rises in decades. Japanese companies have been able to increase prices too, which has helped profitability.
Bear in mind that the country was not completely unusual in doing this. After the financial crisis, central banks cut interest rates to stimulate economies, encourage borrowing by consumers and lending by banks.
In the eurozone, deposit rates set by the ECB were negative from 2014 to 2022. The Bank of England's record low rates hit 0.10% and the Federal Reserve had the federal funds rate close to 0% in 2020. The low interest rate policy was effective in the West in terms of encouraging asset price inflation in property, bond and stock markets. For a while it seemed as if this could be achieved without introducing inflation, which was an expected consequence of quantitative easing (QE). Russia's invasion of Ukraine, the covid pandemic and other factors brought this complacency to an end and central banks scrambled to hike rates to suppress price rises.
Japan's Sluggish Economy is Reviving
Japan's malaise was just more extreme and economic slump was more protracted than in other developed countries. For many years it felt like the negative interest rate policy was not working because inflation remained elusive. People didn't want to save (or invest) and they didn't expect pay rises either.
After a period of high inflation in the West, a period of falling prices (deflation) would seem desirable. But deflation can be as damaging as inflation: consumers stop spending on non-essentials because they expect prices to fall. Saving is also perceived to be ineffective because interest rates are so low. And companies make less money because they can't raise their prices, and are actually expected to cut prices. Workers can't bargain for higher wages because employers know prices are falling. Their employers may actively consider cutting jobs because their profits are weakening, creating a spiral that can lead to recession.
Morningstar analyst Lorraine Tan argues the BoJ is likely to be cautious: "we think the BoJ will be prudent in its moves to raise rates further, given that the Japanese government bears the risk of having to pay higher interest costs.
"Also, with more than 80% of borrowers holding floating rate debt, large moves are likely to be avoided. While interest rates are rising, they remain at a low level and we do not expect any impact on loans demand and see loans growth maintained at a low-single-digit pace."
She argues a rate increase will help banks, which should "enjoy stronger earnings growth over the next three years with return on equity, or ROE, increasing." When interest rates rise, banks earn a higher net interest margin (NIM) – the difference between money paid out on deposits and money made on loans.
Should I Invest in Japan Now Rates Have Risen?
But that's all very domestic. Investors in the UK and Europe will want to know if they should change their view of Japan and its markets.
"We think the main reason overseas investors can be long-term positive on Japan is the return of inflation will provide a boost to spending and drive capital reinvestment," Tan says.
"Its decades-long deflation discouraged Japanese companies from reinvesting domestically and also saw house prices slip. Now that there appears to be some prospect of rising prices, we hope that this will lead to a sustained changed mindset towards domestic investment, and that this will lead to increased consumption.
"However, should the yen appreciate as quickly as it fell, some of these drivers could be diminished. We think overseas investors, however, should be hedged in that regard as a strengthening yen should help counter a possible slip in share prices."
In a recent seminar, Pictet Japan fund manager Sam Perry argued the link between a stronger yen and weaker equity returns was not grounded in reality. Neither is there any sense that, domestically, Japan is in bubble territory, he said.
"Strange things are happening in small parts of the market," he said, but overall Japanese retail investors are not gripped by trading frenzy – which is often a sign a market is about to collapse.
Japanese Bonds: on The Menu Again?
But the most obvious impact of all will be on fixed income.
"The BOJ's 19 March policy changes, while largely anticipated, should have minimal immediate market impact, says Tomoyo Masanao, co-head of Asia-Pacific portfolio management and co-head of PIMCO Japan.
"However, the medium- to long-term implications could be significant, as the potential scale of the BOJ's policy changes may be more than the financial markets currently anticipate."
"For investors, the Japanese bond markets should start offering a higher risk premium and modestly higher yields in response to the BOJ's continued policy adjustments and the transition of government bonds back to market forces.
"As the market digests the new and evolving policy stance, there will be tactical opportunities for active managers to capitalise on the inefficiencies in the Japanese bond and interest rate swap markets during this period of increased volatility."
As such, investors, wary of the market for obvious reasons, may be drawn back into Japanese bonds as yields improve.
