Text size

The Japanese yen has fallen sharply against the US dollar this year, which could create another destabilizing force for the global economy.

Behrouz Mehri/AFP via Getty Images

Investors looking for trouble spots as the Federal Reserve raises interest rates by 0.75 percentage points – the biggest rise since 1994 – may want to keep an eye on the Japanese yen’s sharp decline against to the US dollar.

Not only could the weaker currency exacerbate the inflation that the Fed is so worried about, but it could also create another destabilizing force for the global economy.

The Japanese yen has weakened against the US dollar by around 32% since January 2021 and 14% since March. This is a sea change for the stilted currency market, underscoring the level of volatility facing investors beyond stocks and bonds. “It could get messy,” says Exante Data founder Jens Nordvig, warning that domestic Japanese investors haven’t even started selling yet.

Yen weakness is a by-product of divergent monetary policy. While the Federal Reserve is tightening much more aggressively than expected just a few months ago, the

Bank of Japan

is one of the few to stick with looser monetary policy and even add stimulus through balance sheet measures, says veteran currency strategist Marc Chandler of Bannockburn Global Forex, who considers such moves as another sign of a bearish bond market.

While much of the world is obsessed with inflation, Japan has fought decades of battle against deflation, one reason it hasn’t been as hawkish as its central bank counterparts in the United States. and in Europe. But she too does not want inflation. After all, its aging population depends on fixed incomes. Inflation is kryptonite for these assets, and weak currencies can exacerbate inflationary pressures, says Jack McIntyre, head of the global fixed income team at Brandywine Global.

Additionally, as an importer of energy and food, Japan now faces sharp increases in crucial commodities and a weaker currency to pay for them. With elections in Japan next month, political pressure for the central bank to “do something” to stem the declines is mounting.

Now the Bank of Japan must choose between controlling its exchange rate or its interest rate and possibly abandoning its yield curve controls from a 25 basis point target for Japanese government bond yields to 10 year. In recent days, the Bank of Japan has already tried to intervene verbally to strengthen its currency, but McIntyre says real intervention could be likely.

That, too, could be dangerous and costly in reserves that Japan might need to spend, especially at a time when the currency isn’t so out of whack relative to fundamentals, Nordvig says. If Japan were to sell Treasuries, it would push Treasury yields higher and put even more pressure on the dollar/yen, adding another source of volatility. Moreover, an intervention could also attract speculators who exacerbate the situation, requiring even more reserves from Japan to stabilize the situation.

Any intervention would likely require a policy change. Since Japanese government bonds are the anchor for global bond yields, any change would ripple through the markets.

Could the falling yen be a canary in the coal mine? Maybe, says McIntyre, noting the inflationary backdrop globally. “Nobody really wants a weak currency in this environment. From that perspective, maybe we’ll start to see other governments, central banks in particular, push back against weaker currencies,” McIntyre said.

A competitive devaluation among Japan’s export rivals in Asia, including China, would only add stress to a fragile economy. The Chinese Yuan, for example, has been a source of low volatility acting as a stabilizer for global trade. Moving away from that would be another major source of volatility.

US companies will feel the impact of a strong dollar, with the US Dollar Index (DXY) hitting its highest level against major peers since late 2002, as they convert foreign earnings into US dollars.

Microsoft

(MSFT) has previously warned of a $460 million hit in the fourth quarter due to currency swings.

In theory, the strength of the dollar could mean that foreign stocks are more attractive than US stocks. But in reality, according to strategists at TS Lombard in a note, the currency backdrop is adding to cost pressures from already squeezed margins and “creating a destabilizing force in an already fragile global economy.”

The concern: Further dollar strength could hurt international trade, squeeze the balance sheets of emerging markets that have borrowed in dollars and intensify what is already a significant tightening in global financial conditions, according to TS Lombard.

The yen should be on the list of what could “break” due to divergent central bank policy. That means all eyes will be on Friday’s Bank of Japan meeting.

Write to Reshma Kapadia at [email protected]