For the first time in eleven years, the interest rate for long-term bonds has risen above 1 percent. Investors will have to factor in such surprises in the future.
Japan’s monetary policy turnaround has reached another milestone. On Friday, the interest rate on ten-year government bonds (JGB) rose above the 1 percent mark for the first time in eleven years, reaching 1.005 percent. This alone is something special in Japan, as the Bank of Japan has kept the interest rate on long-term bonds at 0 percent from 2016 to 2022. Kazuhiko Sano, bond analyst at Japanese broker Tokai Tokyo Securities, described the rise to 1 percent as unexpected.
The reason for the rise in interest rates is that the largest owner of Japanese government bonds, the Bank of Japan (BoJ), has been buying fewer government bonds on the market than usual since last week. Martin Schulz, economist at the technology group Fujitsu, sees this as a reaction to the growing pressure on the BoJ to slow the decline of the yen. “The low interest rates in Japan compared to other countries have led to a sustained weakness of the yen,” explains Schulz. “The BoJ therefore wanted to use its action to test the market’s reaction to higher long-term interest rates.”
For Japanese bond analyst Sano, the increase shows that “concerns about a reduction in purchases of long-term bonds appear to be extremely strong.” The reason for this is that the central bank holds around 50 percent of the JGBs and therefore even small changes in their policy can have a huge impact on the market.
The big question for investors now is whether rising interest rates could put an end to the weakness of the yen and thus the record-breaking hunt on the stock market. Japan’s leading index, the Nikkei 225, exceeded its previous high from the time of the speculative bubble in the late 1980s in the spring, driven by the weakness of the yen.
How do higher interest rates affect the economy?
The impact of higher interest rates on the economy is still small. The real interest rate, i.e. the interest rate minus inflation, is still negative in Japan. The inflation rate is currently around 3 percent. However, after abandoning the negative interest rate policy in April, the BoJ has set the key interest rate for short-term bonds at 0 to 0.1 percent.
The negative real interest rate continues to make it cheaper for companies to borrow. At the same time, the real estate market is not greatly affected by the development of the ten-year JGB. Because 80 percent of mortgages now have flexible interest rates, the interest rates on short-term bonds are decisive there. However, further interest rate increases in this JGB class are considered unlikely in the near future, as Japan’s economy is currently not growing and consumption is still below pre-pandemic levels.
Will interest rates continue to rise?
“There is still a lot of liquidity in the market,” says Schulz. “I therefore do not believe that interest rates on ten-year JGBs will rise significantly above 1 percent.” Sano also points out that the BoJ is not using the reduction of its balance sheet “as a monetary policy tool.” In his view, the reduction will be slow at best. However, if the central bank reduces its balance sheet faster than expected, interest rates could rise quickly, says Schulz. He also believes it is realistic that interest rates on ten-year JGBs could rise to 2 percent by 2025 – provided the economy returns to solid growth.
What does the appreciation of the yen mean?
So far, Japanese stocks have benefited from the sharp fall in the yen. The weaker the Japanese currency becomes, the greater the impact of foreign profits on the balance sheets of Japanese export companies when converted. Since the yen’s exchange rate against the dollar and the euro is currently determined primarily by the interest rate differential between Japan and other countries, investors fear that the yen could rise again due to rising interest rates on long-term bonds.
So far, however, the foreign exchange market has barely reacted to the change in monetary policy. According to Schulz, the exchange rate currently depends mainly on whether the American Federal Reserve raises or lowers interest rates. He is currently assuming that the yen will stabilize at a low level. Inflation in the USA is stubborn and rapid interest rate cuts are unlikely. At the same time, the high level of foreign investment in Japan will not reverse the trend, as Japanese private investors are continuing to invest heavily abroad.
What does this development mean for Japanese stocks?
Sho Nakazawa, strategist at Morgan Stanley MUFG, sees Japan’s stocks continuing to rise, thanks in part to higher inflation. The price surge is causing nominal gross domestic product, which had stagnated until 2022, to suddenly grow strongly. For Nakazawa, this is good news: “Higher nominal growth could have a positive impact on asset prices.”
Other possible price drivers are the corporate governance reforms with which many companies want to increase their profits, dividends and share buybacks for the benefit of their shareholders.
Alexander Redman, chief strategist at Citic CLSA in Singapore, is particularly focused on the Asian emerging markets and China. In his view, the yen is one of the reasons why he no longer overweights the Japanese stock market.
He still believes that the Tokyo Stock Exchange’s Topix index could rise by a further 5 percent in the next twelve months, or 10 percent in dollar terms. “But I don’t think that Japan will be able to continue to outperform the other markets in the region.”
Schulz believes the risk of a bear market in Japan is low. The weakness of the yen has been priced in. “But if the economies in Europe and China improve, export companies there could profit more again,” he says. “I therefore do not expect share prices to collapse due to rising interest rates.”
What role could Japanese bonds play in a Euro investor’s portfolio?
Economist Schulz believes that Japan could currently be of interest to large bond investors who can react quickly. In the past, European homeowners have taken advantage of the falling yen to finance their mortgages in the Japanese national currency. “For private investors, however, I consider Japanese bonds to be too speculative due to the potentially high currency risk,” says Schulz.
The yen is already very weak. And if the trend reverses, you could get your fingers burned, as happened to Austrians and Eastern Europeans in the past with yen-based bonds.
What effects can be expected on the global capital market?
So far, the Japanese have mainly used the higher tax allowances for securities investments introduced at the beginning of the year to invest their money abroad. Even with slightly higher interest rates, Schulz does not expect the Japanese to withdraw from dollar investments. US Treasuries in particular remain popular.
On the one hand, Japanese private investors in particular are very skeptical about the performance of Japanese companies because the domestic economy is weakening. “In addition, the stocks are already very highly valued from their perspective.” Foreigners see things differently. CLSA strategist Redman currently sees the Japanese Topix at a price-earnings ratio of almost 16. This means that Japanese stocks are already valued higher than European stocks, but still lower than American stocks.