Here are some thoughts on the deeper dynamics at play in the current round of Yen depreciation. It is a somewhat lengthy opus, not because currency forecasting is particularly difficult - it is not, at least not at the moment; but because the Yen offers a unique window into the workings of Japanese capitalism in general, policy makers’ priorities in particular.
If that scares you from reading, let me start with a quick bullet point summary of real-world implications:
A parabolic move towards Y150-160/$ is increasingly likely
BoJ Governor Kuroda is right in insisting on a de-coupling from the Fed tightening cycle — there is no demand-pull inflation in Japan
The Yen depreciation cycle will end when Japanese investors begin to buy their own domestic risk assets
They will do so only when corporate leaders begin to present credible, pro-growth business plans
How do we know when that time has come? — watch out for whether/when Japan’s ultimate insider, the GPIF public pension manager, cuts US allocations and raises Japan exposure
Well, here we go for the real thing :
The Yen’s Fall From Grace
The Japanese Yen is on track towards a parabolic move, with global- and Japanese macro players set to get increasingly aggressive in betting on an overshoot towards Y150-160/$.
Why? Because the same economic forces that pulled the Yen out of the remarkably stable Y105- 110/$ range it was boxed in for the past six years are poised get even stronger in coming months. No mystery, no magic, no speculative excess - we got to Y128-131/$ because of a de-coupling of monetary policy. With Governor Kuroda digging in his heels and the Fed increasingly determined to boost its inflation fighting credentials, it very much looks like the Yen`s slide is just beginning.
Policy makers: a united America versus a disjointed Japan
America is mobilizing an all-out attack on inflation -- raising rates, cutting the central bank balance sheet, and, importantly, policy makers, 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 America`s monetary brakes will start to cut into demand; but everyone agrees that a strong dollar is good for America`s fight against inflation: 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 in both action and in talk that nothing has changed, that deflation is still viewed as a bigger threat than inflation.
More important for investors looking for clues about the Yen`s direction: neither the BoJ, nor METI or MoF; nor 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 and others argued a 7-8% inflation target may be necessary to snap Japan out of deflation....
Personally, my work and investments away from macro theory, particularly the hands-on deep-dives into Japanese companies, the dealings with corporate CEOs and institutional CIOs, as well as direct policy- making engagement with Japan’s industrial structure and demographic realities all have me convinced inflation/deflation here is not much of a monetary phenomena, 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, 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 vainglory 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, i.e. it follows neo-liberal 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 over the Yen, 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 American policy elite beginning to act and poised to act 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 equals weaker Yen` trade.
That’s why I think an overshoot towards $150-160/$ is more probable than a return to the Y105- 110/$ range seen until a couple of quarters ago. Speculating against the Yen has an asymmetric risk-reward profile right now.
How long will this last? What forces could break the current dynamics? Because, yes, eventually Japan will follow the US lead. The BoJ always does. The one time it did not and insisted on a de-coupling from US policy, Japan got its Bubble Economy. Nobody, least of all Prime Minister Kishida, wants to go through that again.
Can PM Kishida persuade BoJ Governor Kuroda to change his mind?
Probably not, at least not until it becomes clear that Kishida is here to last –there is an upper house election in July; and after that, yes, PM 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, i.e. an eternity for currency markets.
Again, the contrast between America and Japan is striking. For President Biden inflation is an immediate and present danger, a key reason for his continuing drop in popularity. Against this, Kishida`s popularity keeps climbing and inflation running at barely 1% 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, Kishida is more likely to add to a yen-depreciation speculative frenzy.
Why not?
First of all, Governor 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 Governor who tightened too early.
And politically he understands more than anyone the risk 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 looser if/when interest rates go up go up too early, i.e. before domestic demand, and thus tax revenues, have entered a self-sustaining upcycle.
And secondly, 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 America. Again, it is difficult to argue against the Yen depreciation momentum accelerating in the immediate future.
When the facts change...
But what about more longer-term? What structural dynamics could unfold that could trigger a reversal of fortune for the Yen? Here are five primary forces that can or will force a change of direction from Yen depreciation towards appreciation:
the US or China accuses Japan of starting a currency war
The US 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 Yen-led currency war...
Right now, the risk of Japan being accused of starting a currency war are low. If I am right and America`s elite is indeed united in fighting inflation, it will continue to welcome a strong dollar/weak Yen.
But what if China were to complain about excessive Yen weakness? They did so the last time the Yen weakened past Y135-140/$ in mid 1998. At that time, China successfully persuaded the Clinton administration to publicly abandon the strong dollar policy America ran at the time.
But times have changed. Today, in 2022, Chinese complaints are unlikely to get much of a hearing in Washington. In 1998, America was focused on getting China to join the World Trade Organization and was happy to try and be helpful. Today, America regards China as its principal competitor while Japan position as its principal ally in Asia is firmly re-established. The more you belief the `New Cold War` rhetoric as an overarching US policy priority , the less you will worry about China triggering an end to Yen depreciation.
...towards a US-China agreement on Renminbi devaluation?
However, rather than being lulled into a false sense of security by mainstream Washington rhetoric, a pragmatist investor will constantly evaluate actual policy developments. Specifically, the latest overtures to China made by Treasury Secretary Yellen, suggesting US readiness to negotiate 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 pay almost four- times more for imports from China than they do for imports from Japan ($541 billion from China, $140 billion from Japan, in 2021). If a weak Yen / strong dollar 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 America are now complementary – China wants inflation, America wants deflation.
Although very much a long-shot given President 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 America would add new fuel to the Yen`s decline. So while the risk of America accusing Japan of currency manipulation and engaging in a currency war is low, the possibility of America tolerating 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 America`s best interest forever. The turning point will come when US recession and deflation risks overpower the current inflation pressures. More specifically, that point comes when Fed rate hikes begin to cut into US asset prices in general, US equities in particular.
Never before has the combination of rising rates and falling corporate profits not brought troubles on Wall Street; a bear-market at best, a crash at worst. And nothing will focus the mind of America`s policy elite as the specter of asset deflation.
The numbers speak for themselves. With just about 40-45% of US listed companies 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 America `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 appears to be 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.
...to US stagnation fueling protectionism in the run-up to the 2024 Presidential election
The bad news is that reality probably won`t be that clearcut. 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. suborn but no longer accelerating inflation, with growth (and Wall Street), not crashing, but 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 policy makers 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 dynamics is that US stagnation is poised to fuel a next wave of protectionism.
Blaming ‘unfair’ cheap imports, pointing to China, Mexico and Japan and accusing them of taking jobs from American workers become more tempting narratives the longer stagnation depresses any `feel good factor` amongst American voters. Not now, in my view, not for the 2022 mid-term elections (inflation is the more immediate problem this year); but it become 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 amongst 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 and `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 US stagnation risks, the greater the risk of America abandoning its current strong dollar policy. Moreover, who will want to buy or hold dollars if US interest rates and US equities and US 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 US 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; and who will do the buying?
The last point is key, in my view. There is plenty of great analysis demonstrating Japan is cheap; here just some highlights:
Japanese equities trade on a 13-times PE multiple, which is cheap against its own 30-year history as well as against the 22-times PE you pay for the US (TOPIX vs SPX500).
Japanese labor costs are now down to half (!!) of US ones, $34k in Japan versus $69k in America (average per capital annual income)
A Big Mac costs Y399 in Tokyo, versus $5.30 in LA, so a US tourist could get two-for-one..
…if only Japan allowed free inbound travel.
Personally, I think the most immediate and impactful way to begin creating new marginal demand for Yen is for PM Kishida to open Japan`s borders. Inbound tourists spent approximately Y5 trillion per annum before they were shut-out. Although small in absolute terms relative to the approximately Y500 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 & 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 think computer coding, IT and other location agnostic service workers – a zoom Yoga class from a Tokyo teacher is now almost half-price compared to one taught by an LA or NY based yogi.
In fact, several US and Israeli venture capital firms have begun scouting for Tokyo, Fukuoka and Osaka based software engineers to do work they originally had planned to get done in Vietnam. Again, Japan engineers are now about 30% cheaper than their Vietnamese competitors (never mind Silicon Valley ones).
Clear speak: The combination of relative cheapness coupled with 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 proximity to suppliers. Just look at how difficult it was for the government to persuade TSMC and SONY 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, unlikely in my view. Watch for a pick-up in inward direct investment, with more service sector global giants buying into Japan, following Paypal`s $2.4 billion aquisitiion of Tokyo start-up Paydy last year, and the growing success story of Salesforce or Amazon or Yahoo or law firm Morrison & Forester here in Japan, to name just a few.
Clear speak: in coming months I shall watch carefully for signs of a pick-up in cross-boarder 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/US assets, the case for Yen appreciation will be hard to substantiate.
Here it is interesting to recall the history of the worlds single biggest asset manager, Japan public pension fund. The GPIF manages US$1.7 trillion, of which approximately 26% are in global bonds and 24% in global stocks. In all the grandstanding about the merits or de-merits of Yen depreciation, it should not be forgotten that Japanese pensioners are thus a major beneficiary of Yen depreciation: a 10% depreciation should create a 2-3% upside performance windfall profit (obviously depending on hedge ratios and equity/bond markets performance). I am not a public pension actuary, but some friends who are suggest it is quite possible that at Y140-150/$ (and on current asset allocation), Japan`s public pension may actually become overfunded.
Importantly, the GPIF contributed greatly to forcing the last major inflection point in the Yen`s fortunes when it announced a major re-allocation out of domestic JGBs into global bonds and equities during the early year`s of the Abe 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 -- public pension fund beats private managers
Yes, Governor Kuroda`s BoJ has launched an all-out attack on deflation in early 2013, but only when Japan`s (and the world’s) largest asset manger began to act and switched asset allocation, only then 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 assets and the GPIF 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 firm- or industry specific employees/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% allocation to non-yen assets by the GPIF, private pension managers have slightly less than 30% 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 pensions 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 general lack of financial professionalism.
The $850 billion question – when will GPIF cut non-Yen allocations?
The bottom-line is this: when predicting the Yen`s fortunes from here, the real focus for practitioners is not so much whether the US treasury will agree to let the MoF sell its US$ reserves: it is whether, or more specifically when the GPIF will cut down on the global allocations that have served it so well since they started buying dollars in 2013/14 when the Yen was at Y80-100/$.
Make no mistake – the GPIF has evolved into the de-facto primary agent for BoJ and MoF monetary policy objectives and stands at the very core of Japan`s capitalism in general, the transmission from savings into investments in particular. The Yen will pivot and start appreciating when the GPIF announces a cut in its global allocation in favor of the deep-value offered by Yen assets.
When will this happen? My money is on right around the time of the Fed’s policy rates hits ‘neutral’, i.e. when equity markets have no choice but to admit that the risk-reward of buying stocks makes no sense. To wit: an equity earnings yield of 5% and falling (because earnings are in a downward cycle), and a risk free rate of 3% and rising will leave no other choice to the financial professionals at GPIF and other institutions. Contrast that to an earnings yield of 7.5% and a risk free rate of 0.2% in Japan, and you know not just where to hide, but where outperformance is likely – here in Japan.
Clear speak – Japan`s deeply engrained reputation as an equity `value trap` will be corrected exactly when Japanese investors begin to re-commit to their home country risk assets markets. If the GPIF were to lead this charge, fellow global long-term investors are bound to follow, sovereign wealth funds in particular. But Japanese investors will have to show us the money...
Kuroda`s end game – how to break the negative correlation between the Yen and Japanese risk assets in general, Japan equities in particular
In my personal view, Governor Kuroda is exactly right to force this realization onto local asset allocators by de-facto encouraging a currency overshoot towards Y150-160/$. 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 over 30-years.
If I am right, the current policy de-coupling between the BoJ and the Fed will lead to a much more fundamental de-coupling: 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 a still 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, i.e. 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.
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, Governor Kuroda is doing his bit by encouraging Yen depreciation, but his efforts will be in vain of Prime Minister Kishida and his stewards of industrial policy to not follow-through. For Japanese corporate profits to rise in spite of Yen appreciation, Japan needs a serious round of industrial re-organization and domestic investment.
This is because Yen depreciation offers a potentially misleading path – at Y110/$ Toyota`s most profitable factories were the ones in America; at Y130/$ the ones in Japan will re-claim 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 firms, and industrial reorganization at the sector- and macro level.
In other words, PM Kishida and his team must focus on removing regulatory obstacles to industry consolidation, incentive 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 firms with outdated technology and old-fashioned customer acquisition strategies are poised to be squeezed out, loose market share, which in turn will force them to either start investing in better human- and physical capital, or have them consider seriously a merger or acquisition.
To wit: in the various industries and sectors –from hairdressers to banks or machine tool makers— in Japan the top three companies on average in all industries command barely 15% of their market, while in the US they control about 33%. This degree of `excess competition` is also born out when comparing listed companies: US equity markets are almost 7-times larger than Japan (by market capitalization), but the number of listed companies is almost the same, 4,266 in the US versus 3,754 in Japan. In other words, Japan Inc. is as good a definition of `red ocean` cut-throat competition as you`ll be able to find.
...to PM 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 firms 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 by more by `zombie companies` that drag down industry- and macro economic performance, productivity and financial returns than 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 de- coupling 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...
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 here at home in Japan.
This is the optimist’s longer term view. Until then, a pragmatist should prepare for parabolic speculative overshoot towards Y150-160/$.
As always, comments welcome.
Thank you for your attention and thoughts ; more soon & many cheers ;-j
PS: this piece was originally written & circulated April 30, 2022, before Japan Optimist started on Substack; it was published by the American Chamber of Commerce, ACCJ
Great article.