Key Takeaways
- The Bank of Japan’s next monetary policy meeting is set for the 18-19 December. Recent comments from the Bank’s governor suggest that a rate hike is on the cards.
- Inflation currently stands at around 3% – a level that contrasts to the sub 1% level it has been at for much of the last decade. Over time it is expected to trend towards 2%.
- Higher Japanese interest rates could disrupt the Yen carry trade and we last witnessed the impact of such a move in the summer of 2024 when the Nikkei index lost 12% in a day.
- The Bank of Japan is signalling its intentions earlier this time round and will likely hint at additional moves further out. We will be watching this theme closely.
This week we take a closer look at Japan and the likelihood of an interest rate hike at the end of December. An upward move now seems a lot more likely than it was just a week ago and that is all thanks to last Monday’s speech from Bank of Japan governor Kazuo Ueda who talked about the “pros and cons” of raising the policy interest rate and that “everything will be considered” at the monetary policy meeting set to take place between 18-19 December.
So why is Japan thinking about raising interest rates? Well, inflation in Japan is now standing at 3% which is down from the recent highs of 4.3% (start of 2023) but considerably higher than where inflation has been over the last 10 years when it was generally below 1% apart from a couple of spikes up to 1.5% thanks to sales tax increases. Japan was in outright deflation in 2016 and again in 2020 and 2021.
With inflation at 3% and the base rate in Japan at just 0.5% it is also worth focusing on the recent history of Japanese rates which were just 0.1% between 2009 and 2016 when they were cut to -0.1%. From 2024 they have been gradually increasing towards the current level of 0.5%.
So, what is next? Japan is expected to see inflation gradually subside to around 2%. The wage growth round – called the ‘shuto’ – in the spring was expected to be used by the Bank of Japan as a guide for the likely timing of the next rate hike but it appears that the Bank is less patient than we thought. Of course, on top of already high inflation we also have the fiscal stimulus announced by recently appointed Prime Minister Sanae Takaichi who is seeking to make a positive impact on the economy. A £135 billion fiscal stimulus package aims to bring some growth to the Japanese economy which if we look at the quarterly GDP data is still relatively soft.
What does this mean for markets? The Yen ‘carry trade’ has been a prosperous theme in global markets over recent years – a trade that is all about borrowing very cheaply in Japanese Yen and investing overseas in higher yielding assets. The size of the carry trade is hard to pin down but the Financial Times estimates it to stand between several hundred billion and a trillion US dollars.
Historically, when the Bank of Japan has hiked rates, we have witnessed significant volatility in financial assets particularly Japanese government bonds but also across other countries bonds. Volatility can also spill over into equity markets. Money is moving back to investing in Japan from overseas and uncertainty over rates always causes volatility. We saw this during the summer of 2024 when an interest rate hike led to Japanese equities falling 12% in a single day.
This time round it feels that the Bank of Japan is doing a better job in terms of signalling their intentions – certainly compared to 2024. That said, a policy move may well alter global capital flows as Japan hike rates and potentially hint at further moves (which appears likely). A further unwinding of the carry trade will disrupt capital flows. Changing investment patterns will be a theme to watch closely and whilst several central banks are meeting in the coming weeks, the Bank of Japan announcements look set to attract much attention.