[Global Focus] The Rise of N, Mrs. Watanabe's Return... Shaking Global Finance?

Expect Policy Changes with BOJ Leadership Change
Yen Value Rising Since Late Last Year
Funds Withdrawn to Avoid Exchange Losses
US Treasury Value Drops, Weak Dollar Expected

The yen, which fell to its lowest level in 32 years last year, has been showing unusual movements this year. It is rising on the back of expectations for a revision of the Bank of Japan's (BOJ) monetary policy. As the yen's value increases, the sentiment for yen carry trade investments is weakening. If the yen carry funds are withdrawn, it is highly likely to accelerate the decline in the value of U.S. Treasury bonds. Additionally, the dollar's weakness due to the yen's strength is expected to speed up the shift in the dollar's status as a safe-haven asset, which is already under threat.

◆The yen, which broke through the 150-yen barrier... entering a rising phase since the end of last year

The yen value per dollar fell below the psychological threshold of 150 yen in October last year, hitting its lowest level in 32 years. While the U.S. absorbed liquidity through high-intensity tightening (4.75 percentage points) over the past year, Japan maintained negative interest rates to prevent deflation, causing the yen's value to plummet. As the interest rate gap between the two countries widened, investors began joining the sell-off of the yen.

However, about a month later in November of the same year, the yen suddenly turned strong. The BOJ intervened in the market by selling dollars and buying yen, initiating a move to "raise the yen's value," which became a turning point. In addition, in December last year, the BOJ raised the fluctuation range of long-term interest rates, which had been fixed at ±0.25%, to ±0.5%. Since 2016, Japan has implemented a yield curve control (YCC) policy, purchasing unlimited government bonds to keep the 10-year bond yield within a certain range. By expanding the fluctuation range, it effectively had the same effect as raising interest rates.

From the Japanese government's perspective, these measures were taken in response to sudden inflation, but the market focused on one signal while observing the series of policies: a sign that Japan would put an end to large-scale monetary easing policies. Due to expectations of interest rate hikes, the yen settled in the 120-yen range in January this year for the first time in six months.

Especially with the replacement of the BOJ governor, these expectations have grown stronger. With Kazuo Ueda assuming office as BOJ governor on the 9th, there is a growing view that changes to the ongoing monetary policy are likely. Due to the side effects caused by the long-term quantitative easing policy, such as rising prices, policy revision is inevitable. The timing of the policy revision is expected to be around next month when Governor Ueda settles into his position. Accordingly, the yen-dollar exchange rate has been fluctuating slightly since February, remaining in the low to mid-130 yen range.

◇Global financial markets trembling over yen strength... concerns over large-scale investment withdrawals

However, some view this yen strength with concern. They believe the time is gradually approaching when those who used ultra-low interest rate yen to purchase overseas assets will liquidate their yen carry funds and repatriate their investments.

[Image source=Reuters Yonhap News]

The yen carry trade refers to borrowing yen at zero interest rates in Japan, converting it into dollars or euros, and investing in high-yield overseas assets. These investors profit by selling yen when its value falls and buying when it rises. Yen carry investors are highly likely to withdraw funds to avoid foreign exchange losses if the BOJ shifts to a tightening stance causing the yen's value to rise. Bloomberg estimates that Japanese funds that could exit due to BOJ's rate hikes amount to $3 trillion (approximately 3,870 trillion won).

Japan is the world's largest bond holder and a major player in the stock market, so if these funds are withdrawn, a chain shock could hit global financial markets. Emerging markets would be particularly vulnerable.

Emerging markets have attracted investment funds by offering higher interest rates compared to Japan. Major foreign media explained on the 12th of last month, "If the YCC policy is revised, Japanese investors could repatriate huge amounts, affecting bond yields in Australia, various Eurozone countries, and the U.S. Some emerging markets like Indonesia could face actual capital outflows."

Moreover, a decline in U.S. Treasury bond values is expected. Currently, Japan holds over $1.5 trillion in U.S. stocks and bonds, which is about 7.3% of the U.S. GDP. Japan has invested amounts equivalent to 9.5% and 8.3% of the GDP of the Netherlands and Australia, respectively, in their stock and bond markets. It has also invested about 7.5% of France's GDP, and 4.6% and 4.5% of the UK and Belgium's GDP, respectively.

Additionally, reduced dollar demand and yen strength could fuel dollar weakness. Ahead of the BOJ monetary policy meeting in January, market expectations grew that the BOJ would abolish or ease the YCC. Consequently, the dollar index hit its lowest level in seven months.

Meanwhile, some analyses suggest that yen carry investments are already declining. When the yen's value sharply fell last year, Japanese investors reduced their holdings of U.S. Treasury bonds due to increased dollar borrowing costs and to defend against yen depreciation. Krishna Guha, Vice Chairman of Evercore ISI, stated, "Due to rising foreign exchange hedge costs, Japanese investors have already stopped net purchases of U.S. Treasuries." However, he added, "This is a market shock but not a catastrophic event."

There are also forecasts that the market side effects from yen carry fund withdrawals will not be as severe as expected. Even if Japanese investors withdraw their investments, the rise in U.S. Treasury yields could be limited. Roger Ferguson, former Vice Chairman of the U.S. Federal Reserve, said in December last year on CNBC, "(BOJ's monetary policy revision) could have a significant impact on global bond markets," but added, "I don't want to say the Fed is overly worried. This is a slight change, not a huge one."