Can Japan shield the yen from the dollar?

Key takeaways

• After falling 20% vs the US dollar in 2022, the Japanese government is intervening to support the yen
• BoJ monetary policy remains accommodative and unchanged, in contrast with other developed central banks. A new governor, due in April 2023, may prove less dovish
• The government plans more fiscal spending and greater energy independence through nuclear power
• If monetary policy turns more restrictive, and the economy more resilient, pressure on the yen should fade, creating space for Japanese assets to appreciate. We see the USDJPY trading in a range of 138-145 yen to the US dollar over the next 12 months.

The Japanese government has started defending the yen from further weakness against the US dollar. Whether intervention proves successful, despite continued ultra-low interest rates, has significant implications for Japan’s economy and global currency markets. We expect the government to maintain its exchange rate interventions to address popular discomfort with inflation and the weak yen.

On 22 September, Japan’s Ministry of Finance instructed the Bank of Japan (BoJ) to intervene in currency markets, buying the yen and selling the US dollar, for the first time since 1998. Japan’s finance ministry can decide currency market interventions though it delegates implementation operations to the central bank. The move, as the exchange rate reached USDJPY 145.7, follows a decline in the Japanese currency of more than 20% this year against the US currency, and warnings from the finance ministry that large currency swings were not “desirable.” 

However, the BoJ is not acting in tandem with the government. On the same day that the finance ministry ordered dollar sales to support the yen, Governor Kuroda Haruhiko said in a press conference that the central bank does not plan to hike short-term rates. There may be “no need to change forward guidance for two or three years,” Mr Kuroda added. The BoJ’s -0.1% target rate has been in place since January 2016. The central bank’s 0.25% cap on 10-year Japanese government bond (JGB) yields using asset purchases, a policy known as yield curve control, may undermine the finance ministry’s push against the yen’s weakness.

Although many currencies including the euro, sterling and Chinese yuan have depreciated against the dollar in 2022, the yen has performed worse than most. Monetary policy divergence from the US has been a key factor. The US Federal Reserve has reacted to high inflation by raising interest rates faster and more aggressively than many others, prompting investors to seek the shelter and returns of dollar-based assets. This apparent inconsistency between the government’s currency intervention and BoJ support for the domestic bond market is often labelled “sterilised intervention.” This is less effective than monetary policy tightening through rate hikes and reducing liquidity.

‘Abenomics’ backlash

There are political reasons for Prime Minister Kishida Fumio’s government to try to stem yen weakness, despite the contradiction with BoJ policy. Japan’s inflation has been much milder than other developed markets with headline consumer prices rising an annualised 3% in August, the fastest pace since 1991 excluding temporary consumption tax hikes. In comparison, prices in the eurozone rose 9.1% in August, and by 8.3% in the same month in the US. However, price spikes after four decades of near-zero inflation have upset Japanese voters, according to recent opinion polls. Voters’ displeasure is not only about the yen. They are attributing cost of living pressures to the government’s reflationary ‘Abenomics’, that Mr Kishida inherited from a predecessor, Abe Shinzo, and his allies in a different wing of the ruling Liberal Democratic Party (LDP). Mr Abe’s state funeral last month came in for criticism, and reignited debate around his economic legacy and its impacts.

The government must also take timing considerations into account in its search for yen stability. First, the prime minister will replace the BoJ’s leadership between March and April 2023. That may let Mr Kishida nudge BoJ leadership in a less dovish direction, potentially narrowing the gap between currency market intervention and monetary easing. Second, the US Fed may pause or slow its rate hikes in early 2023 as economic data weakens. That would reduce the pressure on the yen and JGB yields. This is our current scenario for the Fed, and market pricing points to a similar path for US interest rates. Third, the government’s fiscal, energy, and public health policies may provide enough of a boost to the economy to shift the outlook for inflation and the currency.

On fiscal policy, the government is already acting. On 30 September, Mr Kishida called for more fiscal stimulus before the end of October, in addition to existing subsidies designed to cushion poorer households from rising energy costs. The size of the package is still unclear, but we expect it to be larger than JPY 3 trillion, equivalent to around 0.5% of gross domestic product. Mr Kishida has also pledged to restart seven idled nuclear reactors. That may boost Japan’s nuclear power generation by as much as 80%, reducing the need for natural gas imports. While unlikely to be effective this winter, improving energy security will cushion gas market volatility and so reduce inflationary pressures on the yen in 2023. Further, borders will re-open to foreign visitors on 11 October, which should boost Japan’s tourism receipts in 2023. Finally, it is possible that Japanese institutional investors begin to adjust their currency allocations, enhancing the impact of the interventions.

Until visibility on global monetary policy improves, we expect Japan to maintain its currency market interventions. With more than USD 1 trillion of currency reserves, much of it in US dollars and US Treasuries, Japan can afford to intervene until other factors take effect. This “sterilised intervention” is not without risks as it may impact the spread between JGBs and US Treasuries.