As a result, Japan’s monetary policy is effectively at the mercy of its exchange rate, to which it pays extraordinarily close attention. For example, in October 2022, the USD/JPY rate reached 150, its highest level since 1990. In November, the government requested action from the BOJ. And at the BOJ’s December policy meeting, the board decided to expand the YCC band.
What’s more, Japan’s leaders must be mindful not to weaken the yen and impinge on the Japanese people’s cost of living, unleashing a political catastrophe. In other words, for the Bank of Japan, exchange-rate stability is necessary not only for price stability but for political stability.
So, what factors currently influence Japan’s exchange rate fluctuations? While a current account surplus helps maintain confidence in the yen, a sizable chunk of it tends to be directly invested overseas and so doesn’t contribute directly to yen buying. Structural trade deficits and increased carry trades because of interest-rate differentials lead to yen selling. And flows from purchase of Japanese stocks denominated in US dollars increase the correlation between stock prices and exchange rates.
Investors: Heed the Road Signs
Given these factors, we think the BOJ may explore the possibility of a policy change—most likely scrapping the YCC policy while keeping NIRP—should the yen head back toward the 150 level. Such a step would likely cap the yen at around 150 and increase the potential for it to rally back toward 130. It is currently hovering around 140.
An end to YCC would also likely result in a swift repricing in Japanese government bonds, with 10-year yields potentially doubling from current levels of roughly 0.4% to levels approaching 0.8%.
With the yen firmly in the driver’s seat of Japan’s monetary policy, the BOJ must navigate carefully to achieve its goals. Investors who heed the road signs may be best positioned to take advantage of opportunities as they arise.