Japan’s falling yen and fiscal space

This post—our fifth—focuses on the drivers of yen depreciation. Since we started publishing this blog in April, the yen has fallen sharply, sparking repeated official foreign exchange (FX) intervention to halt its decline. On a superficial level, recent yen depreciation is the product of monetary policy divergence, given that the Bank of Japan never joined the post-COVID hiking cycle. But—on a deeper level—the falling yen is really about Japan’s large debt burden, which forces the Bank of Japan to cap long-term government bond yields, preventing it from joining the global post-COVID tightening cycle. In effect, this transfers weak debt dynamics from the bond market to the currency. Yen depreciation is therefore a cautionary tale about letting debt rise unchecked. All that said, the yen is not on course for depreciation without end. Its path is dictated by long-term U.S. yields, which should fall as markets absorb that the recent spike in U.S. inflation was mostly about start-of-year price resets. This should help move rate differentials in favor of the yen, halting its decline.

Yen weakness is really about fiscal space

The scale of yen depreciation in recent years is startling. As Figure 1 shows, the yen has fallen more in real effective terms than the Turkish lira, which long held the distinction of being the weakest currency across the major markets. Indeed, since end-2019, i.e., since just before COVID hit, only one currency—the Egyptian pound—has fallen more than the yen in real terms (Figure 2). Not surprisingly, the scale of this depreciation has sparked debate on its drivers and how much further it can extend.

Figure 1. Real effective exchange rates (CPI-based) across advanced and emerging markets

Figure 2. Real effective depreciation from Dec 2019 to May 2024, in %

On the surface, the fall in the yen is simply about monetary policy divergence, since the Bank of Japan never followed other central banks in the post-COVID hiking cycle. Figure 3 shows the U.S. dollar-Japanese yen exchange rate versus the 2-, 5- and 10-year interest differentials. It is true that Fed hikes post-COVID moved rate differentials sharply against the yen, which coincided with the yen weakening. But it is also true that rate differentials explain a relatively limited portion of yen movements through history. Indeed, rate differentials fail to account for the sharp fall in the yen that has taken place year to date. What is clear is that Japanese investors are back to seeking higher yields overseas, after retrenching in 2021 and 2022 due to elevated geopolitical risk (Figure 4).

Figure 3. Dollar-yen exchange rate vs. 2-, 5-, and 10-year interest rate differentials

Figure 4. Japanese resident portfolio flows into foreign stocks and bonds, in % GDP

On a deeper level, rate differentials are just a manifestation of Japan’s very high government debt, which is forcing the Bank of Japan to cap long-term yields, even as yields globally have risen. As Figure 5 shows, this yield cap is material. Japan’s gross government debt is far above every other advanced economy, yet its 10-year yield is very low. As we noted in our introductory post in April, Japan’s high debt means that the Bank of Japan is forced to buy almost all net new issuance to cap long-term yields, without which the government’s interest expense could quickly become unmanageable (Figure 6). Japan is a cautionary tale about the consequences of allowing debt to grow unchecked. The Bank of Japan yield cap—in effect—transfers the fallout from weak debt dynamics from the bond market to the yen. The main pushback to this view is that Japanese inflation remains low, so there is no harm in capping yields. However, with core inflation on a Western definition around 2%, Japan is no longer the low inflation outlier it once was. The inflationary impulse from recent yen depreciation may no longer be welcome, a topic we now turn to in a discussion of recent official FX interventions.

Figure 5. Government debt vs. 10-year bond yields in the G10 and eurozone

Figure 6. Issuance and purchase of Japanese government bonds, 4-quarter sums in % GDP

Japan’s Ministry of Finance recently intervened repeatedly to stop the fall in the yen, with the scale of this intervention far above that of September and October 2022 (Figure 7). However, this intervention had little effect, because the Bank of Japan’s buying of government bonds—needed to maintain the yield cap—indirectly weakens the yen, i.e., runs counter to Ministry of Finance purchases of the yen. In effect, the Bank of Japan and Ministry of Finance are canceling each other out, a remarkable situation that illustrates just how divided Japan is on the topic of yen depreciation.

Given this divided policy message, speculative yen shorts according to CFTC positioning data have not pulled back materially (Figure 8). That said, the yen is not on course for unlimited depreciation. Its path is dictated by long-term U.S. yields, which should fall as markets price that the recent spike in U.S. inflation was largely about start-of-year price resets. This should help move interest differentials in favor of the yen, halting its fall. The post-COVID period of very sharp yen declines may be ending.

Figure 7. Foreign exchange intervention to support the yen

Figure 8. Speculative yen shorts