Why is the Japanese yen so weak?

The Japanese yen, once a symbol of economic stability, has been experiencing a significant decline in recent times.

This graph shows the yen index as of 29 Apr, 2024 (and also the equity curve of investors who were bullish about yen. Yikes!)

As you can tell, the currency is extremely weak right now. Why is that?

Diverging monetary policy: A tale of two central banks

Understanding currency exchange rates requires appreciating the role of monetary policy.

Central banks use various tools, primarily interest rates, to influence economic activity and inflation. In the current scenario, a stark contrast exists between the Bank of Japan (BOJ) and other major central banks, particularly the US Federal Reserve.

The BOJ has maintained a policy of ultra-low interest rates for years, aiming to stimulate a stagnant Japanese economy. This approach keeps the yen cheap, encouraging borrowing and investment within Japan.

However, for international investors seeking higher returns on their investments, the yen becomes a less attractive option compared to currencies backed by central banks raising rates.

This interest rate differential creates a significant force pushing the yen's value down, as investors go long on other currencies and short yen, utilizing a strategy called the carry trade.

The BOJ and the inflation balancing act

The BOJ's commitment to low-interest rates stems from its focus on achieving stable inflation. Unlike other central banks currently prioritizing inflation control through rate hikes, the BOJ believes that stimulating economic growth remains the primary objective for Japan.

This strategy has its merits: low rates make borrowing cheaper for businesses and consumers, potentially boosting economic activity and raising prices.

However, maintaining low rates while inflation picks up globally creates a complex situation.

The yen's depreciation can exacerbate import costs, pushing domestic inflation higher. The BOJ faces a delicate balancing act – stimulating growth without igniting uncontrollable inflation, which could further weaken the already vulnerable yen.

Beyond interest rates: Structural factors at play

Japan's population is rapidly aging, with a shrinking workforce and a potential decline in long-term economic growth. This demographic shift can lead to lower demand for the yen, impacting its value.

Furthermore, Japan relies heavily on imports for resources and energy. A weaker yen makes these imports more expensive, potentially weighing down economic activity and consumer spending.

This creates a feedback loop: a weaker yen raises import costs, pressuring the economy, which in turn reduces demand for the yen, perpetuating its depreciation.

Geopolitical risks and the elusive safe-haven status

Historically, the yen has been viewed as a safe-haven currency.

During periods of global uncertainty, investors often flock to these currencies, perceived as stable and reliable. However, recent global events have cast a shadow on the yen's safe-haven status.

Geopolitical tensions and conflicts can trigger risk aversion among investors. Traditionally, safe-haven currencies like the yen would appreciate in such scenarios.

However, the interplay of Japan's low-interest-rate policy and its economic vulnerabilities might be causing investors to look elsewhere for safe havens. The yen's recent depreciation during periods of global turmoil suggests a potential shift in investor behavior.

The future of the yen: Uncertain winds

Predicting the future trajectory of the yen is a complex task. The BOJ's policy decisions will significantly impact the currency's value.

If the BOJ remains committed to low rates, the yen might continue to weaken. However, a policy shift towards raising rates could offer some support. An intervention in the currency market would also impact the strength of yen, at least in the short term.

External factors like global economic conditions and geopolitical stability will also play a role. A slowdown in the global economy could weaken demand for the yen, while heightened geopolitical tensions could trigger safe-haven flows, potentially strengthening the yen.

Ultimately, the future of the yen remains uncertain, influenced by a confluence of internal and external forces. The future of the yen hinges on the BOJ's policy decisions and external economic forces. As the global economic landscape continues to evolve, the interplay of these factors will determine the yen's fate.

In the meantime, more trips to Japan anyone?

That’s it for today!

Got questions? Feel free to drop me a note. I respond to every email.

I’ll see you soon!