The writer is co-head of currency strategy for Goldman Sachs
The yen has been the worst performing major currency this year, slipping around 12% against the dollar and even underperforming the Turkish lira and Argentine peso.
Against a basket of trading partner currencies and adjusted for inflation, the yen has fallen to levels last seen in the early years of the Reagan administration, before the 1985 Plaza Accord.
But this state of enyasu (weak yen) is likely to be short-lived. The yen is an undervalued safe-haven asset at a time of growing recession risks around the world and structural threats to the dollar. It will find support from long-term investors looking to protect their capital. If global inflationary pressures remain high, the Bank of Japan will eventually let bond yields rise, rather than let the currency tumble.
The recent depreciation of the yen reflects shorter-term cyclical factors: the sharp rise in bond yields in the United States and Europe, the rise in commodity prices which leads to an increase in the import bill for Japan and the wave Omicron Covid, which has stalled the process of economic reopening across Asia.
The BoJ was right to say last week that Japan’s cyclical stance – low core inflation and a more limited rebound in economic output – warrants looser monetary policy relative to its G10 peers.
But structurally, the Japanese economy is not that different from other developed markets. There was an earlier and larger housing bubble and bust, but the pattern was largely the same as that which has unfolded in Western economies over the past decade.
Japanese inflation has been low, but elsewhere inflation rates have approached levels comparable to those in Japan over the past economic cycle. Between 2010 and 2019, consumer price index inflation in Japan averaged 0.5%, compared to 1.4% in the euro area, 1.1% in Sweden and zero in Switzerland. Over the same period, real per capita growth in Japan’s gross domestic product averaged 1.3%, slightly above the average for the rest of the G10.
Moreover, Japan has the attributes of a natural “refuge”. More importantly, it is a wealthy nation with a large stock of foreign assets. Japan holds about 1.26 trillion yen in foreign assets ($9.6 billion) against liabilities of about 850 billion yen ($6.5 billion).
This net international asset position amounts to about 75% of Japan’s GDP and generates revenue for the country of nearly 4% of GDP each year. The Japanese government has a large stock of debt, but this is mainly held as an asset by its residents and the BoJ. The nation of Japan is not going bankrupt and its large current account surpluses over the years mean that the currency is not vulnerable to sudden capital flight.
Investors should be more wary of Japanese bonds than the currency. If we have entered a period of stubbornly high global inflationary pressures, Japan will not be immune. Between 1960 and 1989, when US inflation averaged 5%, Japanese inflation averaged 5.6%—there is nothing in Japan that implies sustainably low inflation.
The low wage growth and price inflation trends in the country will not change overnight. Inflation expectations seem anchored at relatively low levels. It may take repeated inflation surprises for the Japanese public to expect a steady rise in the price level. But that now appears to be a significant risk. Most other economies saw a wave of price pressures as they reopened.
For the BoJ, which has been trying for years to end deflation, this should be good news. Bringing core inflation closer to the central bank’s 2% target will allow it to bring nominal interest rates above zero and improve policy flexibility.
BoJ Governor Haruhiko Kuroda is expected to prepare for his victory lap. Ending negative rates and a yield curve control policy — which effectively caps 10-year government bond yields at 0.25% — wouldn’t be a tragedy. Instead, it would signal that officials have succeeded in ending deflation through a sustained macroeconomic campaign within government.
The yen could very well come under further depreciation pressure in the coming weeks – it goes without saying that we are going through a complex and volatile time for global markets. But beyond the short term, there are a number of recovery avenues for the yen.
In the event of a recession, US Treasury yields and commodity prices would likely decline, narrowing interest rate differentials with Japan and lowering the cost of its commodity imports. If global inflation remains elevated, low interest rates in Japan will eventually move closer to levels in other developed markets.
Investors can anticipate a rebound in the yen over time and should consider holding this safe-haven asset as a hedge against the global recession and other tail risks.