Yen set to weaken – eventually

One of the reasons Japan has been able to sustain its high government debt and deficits at a low cost, is that the country has had a structural trade surplus in the past few decades. Resulting private sector savings have been used to invest abroad or in Japanese government debt. Yields on 10-year Japanese government bonds (JGBs) have been below 2% for over a decade now (and around 0.79% currently). Another result of the private sector savings that have partly been flowing abroad is that Japanese investors have been repatriating these overseas investments in periods of uncertainty about the world economy, causing the yen to strengthen.

Low bond yields and strong yen to last?

Virtually all analysts agree that these ultra-low government financing cost will not be sustained, the only question is when this will change.

The previous combination of downward pressure on JGB yields and upward pressure on the yen as soon as the world economic outlook started to deteriorate, probably means that when the era of cheap government financing comes to an end, so will the upward pressure on the yen.

Eventually, however, yields will rise and the yen will weaken

• Currently, around 94% of Japanese government bonds is in the hands of domestic investors, mainly by large and risk-averse institutional investors such as pension funds. They have to start looking for higher returns in order to meet the growing pension liabilities while their inflows (i.e. pension contributions) are stagnating. In Japan, yields are considered too low, so it is likely that ever more pension funds will start investing abroad

• In addition, Japanese private sector savings are dwindling as the population ages and people start dissaving . Fewer money is then available to invest in JGBs, so Japan will have to rely on foreign investors who will likely demand a higher nominal yield

• Japan is increasingly facing a trade deficit as it has to import all kinds of resources that it does not have itself. This means fewer export profits, and thus less demand for JGBs

• Given the latter three issues, the Bank of Japan is likely to try and keep bond yields low by purchasing large quantities of bonds. After all, even a 1% increase in bond yields will result in enormous losses for current bond holders (bond yields and prices move in opposite directions). This could quickly result in a loss of trust in the yen and Japanese assets

• With the outlook for Japanese exporters worsening now that global growth is slowing, the expensive yen is adding fuel to the fire. Japan is not only becoming less competitive versus European and US firms; as the Chinese renminbi has depreciated versus the US dollar and even more versus the yen, this is making the situation even more dire. The Japanese authorities have dismissed this in the past few months, but with industrial production falling for 3 months in a row, they havecome under increasing pressure to weaken the yen. Foreign exchange interventions are likely, in our view, but this will probably not weaken the yen structurally if historical interventions are any guide. Hence, politicians will pressure the Bank of Japan to substantially loosen monetary policy

Ultimately, as a result of the Bank of Japan stepping up its JGB purchases to fill in the void left by previous JGB investors, trust in the yen can easily fade.

…although this is more a long-term story

For the coming months to perhaps quarters, we do not think the yen will weaken much and JGB yields will rise, for one because BoJ officials are validly concerned that loosening policy and buying up government bonds will be interpreted as monetary financing of the government debts, so there are likely to hold off on aggressive monetary easing for now. Other factors like the raging Eurozone crisis and global capital flows can easily push the yen up and bond yields down, too, for the near term.