Action by the Bank of Japan (BoJ) action to move interest rates on yen bank deposits into negative territory is causing unintended side effects. Negative interest rates are causing the yen to rise, which may hurt Japanese economic growth and Japanese corporate profits.
Some background:
Japan has been experimenting with many options to address their problems with slow growth, deflation, and demographics. One experiment that is not going well is their recent implementation of negative interest rates in their banking system.
In theory, negative interest rates should push up demand for loans and expand capital spending, which will improve production and the general business environment. At the same time, negative rates should (again in theory) cause the yen to fall, and make Japanese exports more attractive to buyers.
In practice, the opposite is happening.
Rather than contend with negative rates on their bank deposits, the Japanese people are moving out of the Japanese banking system altogether. The BoJ has made holding bank deposits so unattractive that they are further worsening the trends they set out to combat.
The Yen is Rising As Interest Rates Fall
We predict that the more the BoJ pushes rates down, the more they will inadvertently strengthen their currency, as people move out of the Japanese banking system into U.S., European, and Asian stocks. (As rates have fallen toward zero over the last few years, Japanese investors predictably closed bank accounts and moved into Japanese stocks.)
The common view of the relationship between interest rates and currency values has been turned on its head in Japan, showing that beyond certain limits, extraordinary measures can become counterproductive.
The common view has always been that lower interest rates cause a currency to fall in value, improving exports and external demand for a country’s products, and eventually strengthening economic growth. Historically, countries have lowered interest rates to stimulate growth.
Negative interest rates are producing a different and unexpected situation in Japan. Japanese interest rates have gone negative, and contrary to the historical pattern of currency reactions to interest rates decreases, the yen is rising strongly. Why? Because the Japanese investor is realizing that a higher yen will hurt Japanese exports and Japanese business profits (Japan is a strongly export oriented economy). The exodus is being driven by investor distaste for negative interest rates, extremely low returns from bonds and bank accounts, and fear of further disruption to corporate profits in Japan. Wary Japanese investors are in effect taking their money abroad by buying foreign stocks.
Besides these observations on the unexpected consequences of Japan’s monetary policy, we also want to note the following for some deeper perspective. Although we are not currently buying stocks in Japan, when we visit Japan, things appear to be good -- society is cohesive and developing, people work hard and are making progress. Although Japan has problems, it is common for the western media to exaggerate those problems -- while on the ground, the Japanese enjoy a high quality of life. We have noticed the same pattern about recent descriptions of the situation in China. In both countries we find the reality to be substantially better than the public perception.
Investment implications: Extraordinary measures from the Bank of Japan seem to have reached a point where they are becoming counterproductive. We are avoiding Japanese stocks until the Bank of Japan -- or the Japanese government -- is more successful in encouraging domestic investment while improving economic growth.