The Yen’s Fall from Grace
Who will stop it? When and why?
Listen to this story:
The Japanese yen is on track toward a parabolic move, with global and Japanese macro players set to become increasingly aggressive in betting on an overshoot toward ¥150–160 to the US dollar.
Why? Because the same economic forces that pulled the yen out of the remarkably stable range of ¥105–110 to the dollar, in which it was boxed for the past six years, are poised to get even stronger in the coming months. No mystery, no magic, no speculative excess. We got to ¥128–131 because of a decoupling of monetary policy. With Bank of Japan (BOJ) Governor Haruhiko Kuroda digging in his heels and the US Federal Reserve now floating the idea of accelerating the pace of rate hikes to possibly 75 basis points a pop, it very much looks like the yen’s slide is just beginning.
Policymakers: United America versus Disjointed Japan
The United States is mobilizing an all-out attack on inflation—raising rates and cutting the central bank balance sheet while, importantly, policymakers, politicians, and opinion leaders are busy signaling that more aggressive monetary tightening will have to come. Nobody knows how many rates hikes are necessary, or when the US monetary brakes will start to cut into demand, but everyone agrees that a strong dollar is good for the United States’ fight against inflation. After all, it reduces import prices.
Japan, in contrast, has a central bank that goes out of its way to keep on buying 10-year government bonds, determined to assure markets—through both action and talk—that nothing has changed, that deflation is still viewed as a bigger threat than inflation.
More importantly for investors looking for clues about the yen’s direction, neither the BOJ nor the Ministry of Economy, Trade and Industry, the Ministry of Finance (MOF), politicians, nor pundits agree on whether a weak yen is good or bad for Japan. Yes, everyone does agree that imported inflation is bad inflation, but many hope that a cost-push shock is just what is needed to break Japan’s deeply entrenched deflationary mindset and expectations. Remember: not so long ago, Nobel Prize winner and chief US economic commentator Paul Krugman, along with others, argued that an inflation target of seven to eight percent may be necessary to snap Japan out of deflation.
“Neither the BOJ nor the Ministry of Economy, Trade and Industry, the Ministry of Finance (MOF), politicians, nor pundits agree on whether a weak yen is good or bad for Japan.”
Personally, my work and investments away from macro theory, hands-on deep-dives into Japanese companies dealing with corporate chief executive officers and institutional chief information officers, and direct policymaking engagement with Japan’s industrial structure and demographic realities all have me convinced that inflation/deflation in Japan is not much of a monetary phenomenon, but primarily a regulatory and structural one.
Specifically, capital markets here are more or less explicitly designed to function far differently from the capital return-maximizing axioms underlying most of monetary policy theory in general, and the transition channels from central bank action to private capital allocation in particular. In my view, Japan Inc. works more in spite of monetary policy rather than because of it. Japan’s elite is far too pragmatic and realist than to entrust allocation of capital to some textbook theoretical models or economics dogma (particularly when they come from Chicago … just kidding).
But what may be true for the economy is not true for the currency. The yen is very much a slave to the masters at the BOJ and MOF. (Arguably, the yen is the only major capital market in Japan where, after decades of deregulation and liberalization, capital does flow relatively unencumbered. For example, it follows neoliberal market principals much more so than is the case in the bond, credit, or even equity markets. This has led to a relative loss of control, with both institutional and retail investors now much less influenced by “administrative guidance” than they were in previous decades.
An Asymmetric Risk
So, right now, if your job is to make money investing in currency markets, the contrast between a united US policy elite beginning to act—and poised to do so more aggressively (on the monetary front)—and a disjointed Japan elite only barely beginning to build consensus on a potentially necessary change, you’d be a bold trader to go against the rising US rates; and stable Japan rates equal weaker yen trade.
That’s why I think an overshoot toward ¥150–160 to the dollar is more probable than a return to the ¥105–110 range seen until a couple of quarters ago. Speculating against the yen has an asymmetric risk–reward profile now.
How long will this last? What forces could break the current dynamics? Yes, eventually Japan will follow the US lead. The BOJ always does. The one time it did not—and insisted on a decoupling from US policy—Japan got its bubble economy. Nobody, least of all Prime Minister Fumio Kishida, wants to go through that again.
Photo: gintsivuskansphoto/123RF.COM
Can Kishida Change Kuroda’s Mind?
Probably not. At least not until it becomes clear that Kishida is here to last. There is an upper house election in July. After that, yes. Kishida gets to appoint Kuroda’s successor early next year. If, by then, inflation becomes a political problem, Kishida may be well advised to pick an inflation hawk. That, however, is at least six to eight months away—an eternity for currency markets.
Again, the contrast between the United States and Japan is striking. For President Joe Biden, inflation is an immediate danger—a key reason for his continuing drop in popularity. Against this, Kishida’s popularity keeps climbing, and inflation running at barely one percent is far from becoming a political make-or-break issue. However, if, against the odds, the prime minister were to pick an open fight with the BOJ before the election, he is more likely to add to a yen-depreciation speculative frenzy.
Why?
First, Kuroda is both intellectually proud and politically pragmatic. He won’t risk his historic legacy of being the governor who beat deflation without seeing firm evidence of genuine demand-pull inflation. He does not want to go down in history as yet another BOJ governor who tightened too early. And, politically, he understands more than anyone the risk that rising interest rates pose to Japan’s fiscal flexibility. With public debt at nearly 2.5-times national income, public finances will be the biggest loser if and when interest rates go up too early (i.e., before domestic demand has entered a self-sustaining upcycle).
Second, markets want to see action and facts, not talk and debate. Show me the money. And with most forecasters now predicting an outright economic contraction during the latest quarter, it’ll get even harder to deny that Japan is indeed at the opposite end of the business cycle from the United States. Again, it is difficult to argue against the yen depreciation momentum accelerating in the immediate future.
When the Facts Change
But what about longer term? What structural dynamics might unfold that could trigger a reversal of fortune for the yen? Here are five primary moves that can or will force a change of direction from yen depreciation towards appreciation:
- The United States or China accuses Japan of starting a currency war
- The United States falls into recession
- Global investors, corporates, or tourists start buying Japan assets
- Japan’s investors and corporates start buying yen assets
- The BOJ starts following the Fed
From Fears of a Yen-led Currency War
Right now, the risk of Japan being accused of starting a currency war is low. If I am right and the US elite is indeed united in fighting inflation, it will continue to welcome a strong dollar and weak yen.
But what if China were to complain about excessive yen weakness? They did so the last time the yen weakened past ¥135–140 to the dollar in mid-1998. At that time, China successfully persuaded the Clinton administration to publicly abandon the strong-dollar policy that the United States was running at the time.
But times have changed. In 2022, Chinese complaints are unlikely to get much of a hearing in Washington. In 1998, the United States was focused on getting China to join the World Trade Organization and was happy to try and be helpful. Today, the United States regards China as its principal competitor, while Japan’s position as its principal ally in Asia is firmly reestablished. The more you believe the New Cold War rhetoric as an overarching US policy priority, the less you will worry about China triggering an end to yen depreciation.
US–China Agreement on Renminbi Devaluation?
However, rather than being lulled into a false sense of security by mainstream rhetoric, a pragmatist investor will constantly evaluate actual policy developments. Specifically, the latest overtures to China made by US Secretary of the Treasury Janet Yellen, suggesting US readiness to negotiate on reducing punitive tariffs still placed on US imports, is a potentially very significant about-turn in US–China economic policy.
Will US economic policy pragmatism prevail after all? Because, yes, Americans spend almost four times more on imports from China than they do on imports from Japan ($541 billion versus $140 billion in 2021). If a weak yen and strong dollar are good news for US consumers, a weak yuan is potentially four times more powerful.
No matter what the new cold warrior rhetoric says, given the deceleration of China growth and threats from asset deflation, the immediate economic policy (and domestic political) goals of China and the United States are now complementary—China wants inflation, the United States wants deflation.
Although very much a long-shot, given Biden’s industrial policy priorities—less from China, not more—a restart of US–China trade negotiations may set the stage for a devaluation of the yuan implicitly tolerated by the US Treasury.
Of course, for Japan and the yen, renminbi devaluation tolerated by the United States would add new fuel to the yen’s decline. So, while the risk of the United States accusing Japan of currency manipulation and engaging in a currency war is low, the possibility that it would tolerate the start of a currency war in Asia may well be underestimated as a next trip wire for dollar strength.
From a Strong Dollar to the Next US Recession
Of course, dollar strength will not be in the United States’ best interest forever. The turning point will come when US recession and deflation risks overpower the current inflationary pressures. More specifically, that point comes when Fed rate hikes begin to cut into US asset prices in general, and US equities in particular.
Never before has the combination of rising rates and falling corporate profits not brought troubles to Wall Street—a bear market at best, a crash at worst. And nothing will focus the minds of the US policy elite like the specter of asset deflation.
The numbers speak for themselves. With just about 40–45 percent of US listed-company earnings coming from global sales, a strong dollar forces weaker earnings. So, while a strong-dollar policy is a welcome tool in the fight against consumer price inflation right now, eventually a switch to a weak-dollar policy will become necessary.
Of course, we can debate whether, in the United States, “this time is different”; whether the threat of stubbornly high consumer price inflation cutting the purchasing power of the people is more important than the loss of capital gains on Wall Street. The Main Street versus Wall Street debate is very real. However, in practical terms for investors, a crash on Wall Street is poised to deliver an about-turn in Fed priorities faster than you can say “American dream.” This is how the dollar’s strong run will end.
US Stagnation Fueling Protectionism in the Run-up to 2024
The bad news is that reality probably won’t be that clear-cut. It is easy to imagine what will happen in the extremes of an inflationary boom and a deflationary bust. What about something more real world, more messy, less clear-cut? Many serious forecasters are predicting a US stagnation scenario—i.e., stubborn but no-longer-accelerating inflation, with growth (and Wall Street) not crashing, rather just meandering and going nowhere.
What are the policy options then?
In my view, the US stagnation scenario will also make it tempting for politicians and policymakers to begin advocating a switch to a weak-dollar policy. The potential windfall to help turn around corporate fortunes is one reason. A more worrying dynamic is that US stagnation is poised to fuel a next wave of protectionism.
Blaming “unfair” cheap imports, pointing to China, Mexico, and Japan, then accusing them of taking jobs from US workers becomes a more tempting narrative the longer stagnation depresses any feel-good factor among US voters. This isn’t likely now, in my view—not for the 2022 mid-term elections (inflation is the more immediate problem this year)—but it becomes a credible scenario for the 2024 presidential fight.
Personally, I worry more about stagnation feeding populism more so than inflation. Under inflation, there are winners and losers. But under stagnation, all you get is an increasingly corrosive disillusionment among every part of society. The American dream very much depends on the celebration of winners; maybe that’s why stagnation will not be tolerated for long. But to get out of it, promises of radical, populist, “only I can fix it” extremist solutions are bound to gain political currency.
Be that as it may, as far as global currency markets are concerned, the higher the US stagnation risk the greater the risk of the United States abandoning its current strong-dollar policy. Moreover, who will want to buy—or even hold—dollars if US interest rates, equities, and real estate prices are going nowhere?
Who Will Buy Japan Assets?
So, it looks like it will become easier to argue for selling US assets as the United States cycle flips from inflationary boom to either frustrating stagnation or deflationary bust. But for the yen to strengthen, investors will have to buy Japan. Why, and when, will this happen? Who will do the buying?
The last point is key, in my view. There is plenty of great analysis demonstrating Japan is cheap. Here are just some of the highlights:
- Japanese equities trade on a 13-times price-to-earnings (PE) multiple, which is cheap against its own 30-year history as well as against the 22-times PE you pay for US equities (TOPIX vs SPX500)
- Japanese labor costs are now down to half (!!) of US ones, $34,000 in Japan versus $69,000 in the United States
- A Big Mac costs ¥399 in Tokyo versus $5.30 in LA, so a US tourist could get two for one
Or at least they could if Japan allowed free travel. Personally, I think the most immediate and impactful way to begin creating new marginal demand for yen is for Kishida to open Japan’s borders. Inbound tourists spent about ¥5 trillion per annum before they were shut out. Although small in absolute terms, relative to the roughly ¥500 trillion daily currency market transactions, creating net new demand for yen is poised to have a positive impact. Markets thrive on new marginal demand.
Welcome to the World, Japan Service Sector Workers and Entrepreneurs
Structurally, the fact that relative Japanese labor costs have fallen so dramatically does open opportunities for more substantial global arbitrage, creating demand for yen. Here, don’t think industrial workers, but rather computer coding, information technology, and other location-agnostic service workers. A yoga class via Zoom with a teacher in Tokyo is now almost half the price of one taught by a Los Angeles- or New York-based yogi.
In fact, several US and Israeli venture capital firms have begun scouting for software engineers based in Tokyo, Fukuoka, or Osaka to do work they had originally planned to have done in Vietnam. Again, Japan engineers are now about 30-percent cheaper than their Vietnamese competitors—never mind Silicon Valley ones.
“Japanese labor costs are now down to half (!!) of US ones, $34,000 in Japan versus $69,000 in the United States.”
Clear speak: The combination of relative cheapness and the realities of remote work and Zoom-based individual services having become more acceptable suggests there is a real chance the world will begin to buy more Japanese services. More specifically, the entrepreneurial opportunities for Japan here are enormous as a much broader section of the service sector transitions from local-only and non-tradeable to global and tradeable. Bonzai classes from a true bonzai master, anyone? This is true not just for traditional Japanese expertise but, more importantly, for newly created Japanese deep tech, patents, and all forms of intellectual property-based innovation. I expect a buying spree by US venture capitalists, snatching up previously hidden innovation bargains created by Japanese private and public scientists and engineers.
Soft Onshoring? Yes. Hard Onshoring? No.
Against this, it is highly unlikely the world will begin to build factories here in Japan. Labor costs are one factor in deciding where to build a factory, but much more important is proximity to market and suppliers. Just look at how difficult it was for the government to persuade Taiwan Semiconductor Manufacturing Company Limited and Sony Semiconductor Solutions Corporation to commit to building a new factory here in Japan.
Labor costs matter in the service sector much more so than in the industrial sector, where capital costs, stakeholder and supplier proximity, and end-market reach are the much more dominant factors. So yes, soft-onshoring—global service sector companies raising their Japan-based footprint—absolutely; but hard-onshoring by industrial companies is unlikely, in my view. Watch for a pickup in inward direct investment, with more service sector global giants buying into Japan, following PayPal Holdings, Inc.’s $2.4 billion acquisition of Tokyo buy now, pay later startup Paidy last September, and the growing success stories of Salesforce, Inc., Amazon Japan G.K., Yahoo Japan Corporation, and law firm Morrison & Foerester LLP here in Japan, to name just a few.
Clear speak: in the coming months, I shall watch carefully for signs of a pick-up in cross-border merger-and-acquisition (M&A) flows into Japan for a possible source of new marginal demand for yen that could help break the current depreciation trend.
Big Guns to the Rescue
When all is said and done, however, Japanese investors hold the key to the fate of the yen. Japan’s status as one of the major global creditors dictates as much. As long as Japanese institutional and retail investors refuse to invest in their own markets and, instead, continue to prefer global or US assets, the case for yen appreciation will be hard to substantiate.
Here it is interesting to recall the history of the world’s single biggest asset manager, Japan’s Government Pension Investment Fund (GPIF). The GPIF manages $1.7 trillion, of which about 26 percent is in global bonds and 24 percent in global stocks. In all the grandstanding about the merits or demerits of yen depreciation, it should not be forgotten that Japanese pensioners are thus a major beneficiary of yen depreciation: a 10-percent decrease in value of the currency should create a two to three-percent upside performance windfall profit (obviously depending on hedge ratios and equity/bond markets performance). I am not a public pension actuary, but some friends who are suggest it is quite possible that, at ¥140–150 to the dollar (and on current asset allocation), Japan’s public pension may actually become overfunded.
“Japanese pensioners are thus a major beneficiary of yen depreciation: a 10-percent decrease in value of the currency should create a two to three-percent upside performance windfall profit.”
Importantly, the GPIF contributed greatly to forcing the last major inflection point in the yen’s fortunes when it announced a major reallocation out of domestic Japanese government bonds into global bonds and equities during the early years of former Prime Minister Shinzo Abe’s administration.
Market participants remember well how the GPIF inflection lent credibility and broader confidence that decades of yen appreciation had come to an end. The GPIF showed the money (with Japan Post Bank and Japan Post Insurance adding welcome firepower).
Performance Pressure: GPIF Public Pension Fund Beats Private Managers
Yes, Kuroda’s BOJ launched an all-out attack on deflation in early 2013, but only when Japan’s (and the world’s) largest asset manager began to act and switched asset allocation did the yen’s fortunes inflect from decades of appreciation towards depreciation. In other words, the GPIF became the primary “agent” for transmitting monetary priorities into the real world.
No, this is not a conspiracy theory. Both the BOJ’s and the GPIF’s assets are owned by the same principal, the Japanese general public. What is interesting, however, is that Japanese private pension managers, whose principals are not the general public but company- or industry-specific employees and pensioners, did not follow the GPIF’s lead and, to this day, have maintained much more conservative allocations to global securities. In contrast to the approximately 50-percent allocation to non-yen assets by the GPIF, private pension managers have slightly less than 30 percent in overseas securities.
Given the now accelerating trend of yen depreciation, the relative outperformance of the public GPIF fund over the private, “independent” ones will, before long, add more pressure for long-overdue professionalization of the stewards of Japanese private-pension schemes. There is no question the GPIF is a best-in-class global steward of capital, while many private pension schemes here are still ensnared in clientelism, cushy amakudari (descent from heaven) positions, and a general lack of financial professionalism.
The $850 Billion Question
When will the GPIF cut non-yen allocations? The bottom line is this: When predicting the yen’s fortunes from here, the real focus for practitioners is not so much whether the US Treasury will agree to let the MOF sell its US-dollar reserves, but whether—or more specifically when—the GPIF will cut down on the global allocations that have served it so well since it started buying dollars in 2013–14, when the yen was ¥80–100 to the dollar.
Make no mistake: the GPIF has evolved into the de facto primary agent for BOJ and MOF monetary policy objectives and stands at the very core of Japan’s capitalism in general, and the transmission from savings into investments in particular. The yen will pivot and start appreciating when the GPIF announces a cut in its global allocation in favor of the deep value offered by yen assets.
When will this happen? My money is on right around the time of the Fed’s third rate hike—i.e., when equity markets have no choice but to admit that the risk-reward of buying stocks makes no sense. To wit, an equity earnings yield of five percent and falling (because earnings are in a downward cycle), and a risk-free rate of three percent and rising, will leave no other choice to the financial professionals at the GPIF and other institutions. Contrast that to an earnings yield of 7.5 percent and a risk-free rate of 0.2 percent in Japan, and you know not just where to hide but where outperformance is likely: here in Japan.
Clear speak: Japan’s deeply engrained reputation as an equity “value trap” will be corrected exactly when Japanese investors begin to recommit to their home-country risk-assets markets. If the GPIF were to lead this charge, fellow global long-term investors are bound to follow—sovereign wealth funds in particular.
But Japanese investors will have to show us the money.
Kuroda’s End Game
How can the negative correlation between the yen and Japanese risk assets in general—and Japan equities in particular—be broken? In my personal view, Kuroda is exactly right to force this realization onto local asset allocators by de facto encouraging a currency overshoot toward ¥150–160 to the dollar. The yen can—and will—be a key force to defeat the deeply entrenched bias against domestic risk assets that Japanese asset allocators have been insisting on for more than 30 years.
If I am right, the current policy decoupling between the BOJ and the Fed will lead to a much more fundamental parting. When Japanese investors begin buying Japanese risk assets instead of non-yen ones, Japanese equities will begin to rise in tandem with yen appreciation.
Although still a long shot at this stage, here is the real escape hatch for Japan from deflation. The long-established negative correlation between Japanese stocks and the currency must be broken. The fact that, for the past 30 years, Japanese equities only go up when the yen goes down while yen appreciation always depresses local stock markets.
“When Japanese investors begin buying Japanese risk assets instead of non-yen ones, Japanese equities will begin to rise in tandem with yen appreciation.”
For this to be supported by fundamentals, domestic Japanese profit margins will have to rise to above those earned from overseas operations and sales.
Here, Kuroda is doing his bit by encouraging yen depreciation, but his efforts will be in vain if Kishida and his stewards of industrial policy do not follow through. For Japanese corporate profits to rise despite yen appreciation, Japan needs a serious round of industrial reorganization and domestic investment.
This is because yen depreciation offers a potentially misleading path. At ¥110 to the dollar, Toyota Motor Corporation’s most profitable factories were the ones in the United States; at ¥130, the ones in Japan will reclaim that spot. However, this windfall is unlikely to last due to the inherent volatility and cyclicality of any exchange rate. As explained above, the moment the Fed changes direction as US recession risks rise, the dollar is set to fall.
From Kuroda’s Cost-Push Stock Therapy …
Sustainable improvements in productivity and profitability will have to be earned through business investment at the level of individual companies and industrial reorganization at the sector and macro levels.
In other words, Kishida and his team must focus on removing regulatory obstacles to industry consolidation, incentivize M&A, and push harder for technological upgrade and capital deepening. Importantly, the current round of cost-push inflation actually creates a strong tailwind for this, because companies with outdated technology and old-fashioned customer acquisition strategies are poised to be squeezed out and lose market share which, in turn, will force them to either start investing in better human and physical capital or have them seriously considering M&A.
To wit, in Japan’s various industries and sectors—from hairdressers to banks to machine tool makers—the top three companies in each command barely 15 percent of their market on average, while in the United States the top three control about 33 percent. This degree of excess competition is also born out when comparing listed companies. US equity markets are almost seven times larger than those in Japan (by market capitalization), but the number of listed companies is almost the same: 4,266 in the United States versus 3,754 in Japan. In other words, Japan Inc. is as good a definition of “red ocean” cut-throat competition as you’ll find.
… to Kishida’s New Capitalism
There is no question that, since the end of the bubble in the early 1990s, Japan’s model of capitalism became increasingly focused on trying to shelter local companies from the forces of asset deflation, technology-induced disruption, rising capital costs, or other forces of “creative destruction” by providing more or less free capital.
Twenty years on, the result is a capitalism marked more by zombie companies that drag down industry and macroeconomic performance, productivity, and financial returns rather than by global top performers. This is where Kishida’s promise of a new capitalism could have real meaning. If new capitalism marks a departure from this zombie capitalism, and actually seeks to incentivize sector-by-sector industrial reorganization and streamlining, then prospects for a sustainable decoupling of Japan’s financial performance from the exchange rate dependency will come into sight. I know this is a big if, but let’s give optimism a chance.
“If new capitalism marks a departure from this zombie capitalism, and actually seeks to incentivize sector-by-sector industrial reorganization and streamlining, then prospects for a sustainable decoupling of Japan’s financial performance from the exchange rate dependency will come into sight.”
Clear speak: if the current pain of cost-push inflation delivers long overdue industrial reorganization and the emergence of true Japanese national champions, the GPIF and other professional investors will be rewarded handsomely—not just from a tactically expedient increase in yen equity allocations because of a Wall Street downcycle, but from a strategic Japan overweight position where yen companies deliver rising returns independent of the currency’s fortunes.
Either way, the yen’s decline will stop and reverse exactly when Japanese investors begin buying their mother markets here in Japan. With a little luck, they’ll do so not just for fear of a US crash, but for realistic expectation that Japanese corporate leaders will not just sweat existing assets but begin to actually invest in both human and physical capital at home.
That’s the optimist’s view. Until then, a pragmatist should prepare for parabolic speculative overshoot towards ¥150–160.
