At around 162 to the USD, the Yen is as weak as it has been against the USD since the 1980s.
The general consensus is that the weakening trend is likely to continue. Reasons cited include Japan’s falling competitiveness due to a lack of productivity growth and increasing overcapacity in Chinese industry – resulting in an explosion of steel and electric vehicle exports, among other products. Similarly, Japan’s trade deficit is further hurt by the increased reliance on expensive energy imports since the Fukushima disaster resulted in the shutdown of nuclear power plants across Japan. Finally, Japan’s headline government debt to GDP is the highest in the developed world.
However, most of these dynamics have been in place for more than a decade, while China’s EV investment and export growth has been observable since 2022. The Yen traded as high as 113 to the USD in 2022.
In a recent article for Bloomberg, 1 Meryn Somerset Webb highlights just how cheap Japan is as a function of the Yen’s pricing. She writes:
“Renting an apartment in Tokyo will cost you only 25% of the same in New York. Buying one will cost half the price of one in London… That’s just the beginning of Japan’s low-cost living: A McDonald’s meal, should you insist on having one, will cost a quarter of the same repast in Tel Aviv”
The Yen weakened as rates rose elsewhere but stayed low in Japan. This dynamic has dramatically shifted over the last 12 months. The spread between the US Treasury 10yr bond and the equivalent JGB has narrowed considerably since late 2024. Yet, the Yen has continued to weaken (one would generally expect to see the two lines in the chart below move in opposite directions):
The Bank of Japan has begun aggressively shrinking its balance sheet, reversing some of the quantitative easing of the COVID period, and allowing bond rates to rise as the ‘yield curve control’ policy has been largely abandoned:
Meanwhile, the US Federal Reserve has stopped its quantitative tightening, taking pressure off US rates.
This has led the spread between the Japanese and US benchmark 10-year bond rates to fall to the slimmest margin since February 2022, when the Yen traded at the 115 level.
The fundamental reason that rate spreads should drive currency movements, assuming equal inflation in each country, is that money tends to flow to where it gets the best return – adjusted for other investor expectations around growth and geopolitical risks. Holding other things equal, increasing rates in Japan while they remain flat in the US should lead to more marginal demand for Japanese yen.
The offsets to this rate dynamic are those mentioned above, plus potentially the disruptive impact to the energy market from the Iran war and Strait of Hormuz closure further hurting Japan’s trade balance and ability to produce manufactured goods due to shortages of key inputs. On the latter point, it is interesting that we did not see the Yen strengthen in the period when the Strait opened to transit – in fact, it kept going the other way, and weakened past the level at which the Japanese Ministry of Finance previously intervened in the currency market by selling ~$72bn of USD.
Further, Japan’s government debt to GDP ratio has been falling thanks to nominal GDP growth – the only major economy where this is the case. The government also plans to return to a primary surplus (ie: before interest payments) in 2027.
Japan’s headline government debt is obviously large, but when one considers that the BoJ (owned by the government) owns more than 40% of the outstanding, the net debt is considerably lower.
Further distorting comparisons between countries, Japan’s massive Government Pension Investment Fund owns assets worth another 40% of GDP, offsetting much of Japan’s future social security liabilities. Contrast this with the US, where unfunded entitlements amount to $78trn – or 244% of GDP, with only $2.9trn pre-funded!
The Japanese government also owns significant stakes in many other key assets, such as Japan Post, telco NTT Docomo, and institutions like the Development Bank of Japan, Japan Bank for International Cooperation, and Japan Finance Corporation. The Bank of Japan also owns around 7% of the entire Japanese stock market via ETFs – worth around US$532bn, or another 12% of GDP.
None of this by itself causes the market’s perception of the Yen to change or for flows to reverse. So what may do so?
The most obvious answer is simply this – time. Major trends often take time to lose momentum and start their reversal. A current example of this dynamic is the observable beginnings of a crash in the Australian residential real estate market. The boom was ignited by ultra-low rates during COVID, but continued even as headline mortgage rates hit 6% in 2023. Rates now are at a similar level, but it took around three years for the higher rates to cause house prices to fall – assisted by the Strait of Hormuz impact on energy prices, and some questionable policies of the Labour government.
A second answer is suggested by Somerset Webb in her recent article, citing comments by Japan’s Finance Minister:
“…look to Finance Minister Satsuki Katayama’s comments this week. Perhaps, she said, now might be a good time to encourage local investors, and the Government Pension Investment Fund (GPIF) in particular, to bring money home. This would be some reversal. Pre-Shinzo Abe’s devaluation drive, the GPIF held 60% of its assets in domestic bonds. Now it is more like 25%.”
How much demand for Yen could a potential shift create?
“If the GPIF went back up to around 30% exposure, companies returned to the levels they held a decade ago and retail investors redirected two years’ worth of investment in foreign equities instead to domestic equities, you get to around $400-450 billion of repatriation. That’s 10% of GDP, and just as it was a “game changer for the Japanese yen” (pushing it down) on the way out, it would be one on the way in (pushing it back up again).”
Whether this occurs or not is uncertain, but the government’s jawboning certainly indicates that the GPIF may face pressure to alter its allocations.
Finally, nuclear power plants are coming back online, with Prime Minister Takaichi a staunch supporter of accelerating the restarts. From her policy speech to the Diet:
“Public and private sector entities will work in concert to accelerate the restarting of nuclear power plants whose safety has been confirmed by the Nuclear Regulation Authority. We will also press forward in bringing into concrete form the development and deployment of next-generation advanced reactors, aiming to construct replacement power plants within the nuclear power plant sites of operators possessing nuclear power plants that have been slated for decommissioning”
So what does this mean for investors, and particularly those with exposure to Japanese equities?
If the Yen strengthens, investors will likely benefit from owning domestic-facing businesses with dollar-denominated inputs that benefit from a stronger yen. Conversely, investors in the large cap-dominated indices such as the Nikkei or Topix will likely face headwinds, as most of these companies are either major exporters or earn a large portion of their profits outside Japan.
A strengthening Yen makes exports less competitive, and reduces reported overseas profits on translation back to Yen.
Key Takeaways:
- Investors may wish to consider being long the Yen directly as strengthening seems likely
- If the Yen strengthens, it will likely benefit domestic-facing companies and hurt large-cap multi-nationals
- If you’re planning a trip to Japan, book sooner rather than later!
