“The BoJ’s strategy of anchoring the 10-year government bond yield at zero implies that changes in foreign bond yields pass through almost completely to the yen,” says Benjamin Mandel, global multi-asset strategist at JP Morgan AM. If global bond yields rise, the interest rate differential with Japanese bonds (which remain unchanged thanks to the BoJ policy) grows, resulting in a weaker yen.
“The fact that this mechanism has been working and that the BoJ remains far from its inflation target suggests near-term inertia in Japanese monetary policy,” Mandel adds.
To hedge or not to hedge?
While a weaker yen is good for companies’ profits and will drive share prices, this doesn’t help if the weakening currency cancels out any profits in an investor’s base currency. So should investors hedge currency risk, which is not unusual for foreign investors to do.
“We always hedge the yen, as we want the performance to come from the equity side, not from the currency,” says Karni. But Assenagon’s Romig notes that not hedging the currency risk results in less volatility over the longer term due to the negative correlation between yen strength and Japanese equity prices.
However, even Romig has hedged his exposure this time as he believes the yen will weaken versus the euro.
“And if the current trend of a weakening dollar stops, Japan could even become more interesting,” he adds. The strongest recent run of Japanese equities happened in the final two months of 2016, when rapidly advancing Japanese share prices coincided with a weakening currency.
But Japan wouldn’t be Japan if everything looked rosy. Prime minister Shinzo Abe’s star has recently started to fade, as his LDP party suffered a historic defeat in regional elections in Tokyo a few weeks ago.
Political risk aside, Japan of course continues to feel the burden of structural problems in its economy. It has been the slowest-growing major economy for over two decades for a reason.
Despite continued sluggish growth, companies are struggling to fill openings, with job vacancies recently exceeding the number of applicants for the first time ever. The tight labour market severely restricts Japan’s potential GDP growth rate, as was noted in a recent report by the OECD. As does the lack of investment by Japanese companies: the dark side of companies’ huge cash balances.