Yen Appreciation and Its Macro Implications

The Bank of Japan jolted global markets after its recent decision to raise interest rates. Our experts break down the effects the move could have on the country’s economy, currency and stock market.

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Chetan Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist.

Daniel Blake: And I'm Daniel Blake, from the Asia Pacific and Emerging Market Equity Strategy Team.

Chetan Ahya: On this episode of the podcast, we will cover a topic that has been a big concern for global investors: Japan's rate hike and its effect on markets.

It's Thursday, August 22nd at 6pm in Hong Kong.

On July 31st, Japan's central bank made a bold move. For only the second time in 17 years, it raised interest rates. It lifted its benchmark rates to around 0.25 percent from its previous range of 0 to 0.1 percent. And at the press conference, BOJ Governor Ueda struck a more hawkish tone on the BOJ rate path than markets anticipated. Compounded with investors concern about US growth, this move jolted global equity markets and bond markets. The Japan equity market entered the quickest bear market in history. It lost 20 percent over three days.

Well, a lot has happened since early August. So, I'm here with Daniel to give you an update.

Daniel Blake: Chetan, before I can give you an update on what the market implications are of all this, let's make sense of what the macro-outlook is for Japan and what the Bank of Japan is really looking to achieve.

I know that following that July monetary policy meeting, we heard from Deputy Governor Uchida san, who said that the bank would not raise its policy rates while financial and capital markets remain unstable.

What is your view on the Bank of Japan policy outlook and the key macro-outlook for Japan more broadly?

Chetan Ahya: Well, firstly, I think the governor's comments in the July policy meeting were more hawkish than expected and after the market's volatility, deputy governor did come out and explain the BOJ's thought process more clearly. The most important point explained there was that they will not hike policy rates in an environment where markets are volatile -- and that has given the comfort to market that BOJ will not be taking up successive rate hikes in an early manner.

But ultimately when you're thinking about the outlook of BOJ's policy path, it will be determined by what happens to underlying wage growth and inflation trend. And on that front, wage growth has been accelerating. And we also think that inflation will be remaining at a moderate level and that will keep BOJ on the rate hike path, but those rate hikes will be taken up in a measured manner.

In our base case, we are expecting the BOJ to hike by 25 basis points in January policy meeting next year, with a risk that they could possibly hike early in December of this year.

Daniel Blake: And after an extended period of weakness, the Japanese yen appreciated sharply after the remarks. What drove this and what are the macro repercussions for the broader outlook?

Chetan Ahya: We think that the US growth scare from the weaker July nonfarm payroll data, alongside a hawkish BOJ Governor Ueda's comments, led markets to begin pricing in more policy rate convergence between the US and Japan. This resulted in unwinding of the yen carry trade and a rapid appreciation of yen against the dollar.

For now, our strategists believe that the near-term risk of further yen carry trade unwinding has lessened. We will closely watch the incoming US growth and labor market data for signs of the US slowdown and its impact on the yen. In the base case, our US Economics team continues to see a soft landing in the US and for the Fed to cut rates by three times this year from September, reaching a terminal of 3.625 by June 2025.

Based on our US and BOJ rate path, our macro strategists see USD/JPY at 146 by year end. As it stands, our Japan inflation forecast already incorporates these yen forecasts, but if yen does appreciate beyond these levels on a sustainable basis, this would impart some further downside to our inflation forecast.

Daniel Blake: And there's another key event to consider. Prime Minister Kishida san announced on August 14th that he will not seek re-election as President of The Liberal Democratic Party (LDP) in late September, and hence will have a new leader of Japan. Will this development have any impact on economic policy or the markets in your view?

Chetan Ahya: The number of potential candidates means it's too early to tell. We think a major reversal in macro policies will be unlikely, though the timing of elections will likely have a bearing on BOJ.

For example, after the September party leadership election, the new premier could then call for an early election in October; and in this scenario, we think likelihood of a BOJ move at its September and October policy meeting would be further diminished.

So, Daniel, keeping in mind the macro backdrop that we just discussed, how are you interpreting the recent equity market volatility? And what do you expect for the rest of 2024 and into 2025?

Daniel Blake: We do see that volatility in Japan, as extreme as it was, being primarily technically driven. It does reflect some crowding of various investor types into pockets of the equity market and levered strategies, as we see come through with high frequency trading, as well as carry trades that were exacerbated by dollar yen positions being unwound very quickly.

But with the market resetting, and as we look into the rest of 2024 and 2025, we see the two key engines of nominal GDP reflation in Japan and corporate reform still firing. As you lay out, the BOJ is trying to find its way back towards neutral; it's not trying to end the cycle. And corporate governance is driving better capital allocation from the corporate sector.

As a result, we see almost 10 percent earnings growth this year and next year, and the market stands cheap versus its historical valuation ranges.

So, as we look ahead, we think into 2025, we should see the Japanese equity benchmark, the TOPIX index, setting fresh all-time highs. As a result, we continue to prefer Japan equities versus emerging markets. And we recommend that US dollar-based investors leave their foreign exchange exposure unhedged, which will position them to benefit from further strengthening in the Japanese yen.

Chetan Ahya: So, which parts of the market look most attractive following the BOJ's rate hike and market disruptions to you?

Daniel Blake: Yes, we do prefer domestic exposures relative to exporters. They'll be better protected from any further strengthening in the Japanese yen, and we also see a broad-based corporate governance reform agenda supporting shareholder returns coming out of these domestic sectors. They'll benefit from that stronger, price and wage outlook with an improved margin outlook.

And we also see that capex beneficiaries with a corporate reform angle are likely to do well in this overall agenda of pursuing greater economic security and digitalization. So that includes key sectors like defense, real estate, and construction.

And Chetan, what would you say are the key risks to your view?

Chetan Ahya: We think the key risk would be if the US faces a deeper slowdown or an outright recession. While Japan is better placed today than in the past cycles, it would nonetheless be a setback for Japan's economy. In this scenario, Japan’s export growth would face downward pressures given weakening external demand.

The Japanese corporate sector has also around 17 percent of its revenue coming from North America. Besides a deeper Fed rate cut cycle, will mean that the policy rate differentials between the US and Japan will narrow significantly. This will pose further appreciation pressures on the yen, which will weigh on inflation, corporate profits, and the growth outlook.

And from your perspective, Daniel, what should investors watch closely?

Daniel Blake: We would agree that the first order risk for Japan equities is if the US slips into a hard landing, and we do see that the dollar yen in that outlook is likely to fall even further. Now we shouldn't see any FX (foreign exchange) driven downgrades until we start bringing the yen down below 140, but we would also see the operating environment turning negative for Japan in that outlook.

So, putting that aside, given our house view of the soft landing in the US economy, we think the second thing investors should watch is certainly the LDP leadership election contest, and the reform agenda of the incoming cabinet.

Prime Minister Kishida san's tenure has been focused on economic security and has fostered further corporate governance reform alongside the Japan Stock Exchange. And this emphasis on getting household savings into investment has been another key pillar of the new capitalism strategy. So, these focus areas have been very positive for Japan equities, and we should trust -- but verify -- the commitment of a new leadership team to these policy initiatives.

Chetan Ahya: Daniel, it was great to hear your perspective. This is an evolving story. We'll keep our eye on it. Thanks for taking the time to talk.

Daniel Blake: Great speaking with you, Chetan.

Chetan Ahya: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or a colleague today.