Japan raised rates. The yen fell anyway

The Bank of Japan raised interest rates for the first time in seventeen years, and the yen fell. It weakened past 151 per dollar, close to multi-decade lows. Currency traders drew a plain distinction between a symbolic policy milestone and the carry trade that actually drives the exchange rate.

Why the yen fell on a hike

Markets trade on surprises, and the decision was no surprise. Reports in the days before the meeting had signalled that the BoJ would end negative rates, and a strong first tally from the spring wage talks removed most of the remaining doubt. What mattered was the guidance, and the guidance was gentle. The bank said it would keep buying government bonds at roughly the same pace as before and gave no hint of a timetable for further increases. Traders who had bought yen in anticipation sold on the news.

Carry still pays

Even with Japanese rates above zero, the gap between the United States (5.3 per cent) and Japan (0.1 per cent) is more than 500 basis points. Kazuo Ueda has promised to keep monetary conditions broadly accommodative, so investors still have every reason to borrow in yen and earn a higher yield abroad. A rate rise that does not tighten policy will not defend a currency.

The mechanics are simple. An investor borrows yen at close to zero, converts them into dollars and buys a Treasury bill yielding above 5 per cent. As long as the yen does not rise by more than the interest-rate gap over the holding period, the trade makes money. Each investor who does it sells yen, which pushes the currency down and makes the trade more profitable for those already in it. Only a sharp rise in the yen, or a narrowing of the rate gap, breaks the cycle.

Japanese money flowing out

The pressure does not come only from hedge funds. Japanese households have long kept most of their wealth in bank deposits paying almost nothing. In January the government expanded its tax-free investment accounts, known as NISA, and much of the new money has gone into foreign equity funds, especially American ones. Japanese life insurers and pension funds, which need returns their domestic bond market cannot supply, also invest abroad. Each of those decisions involves selling yen, and they persist regardless of speculation.

Trade has shifted too. Japan used to run large trade surpluses that brought foreign currency home. Higher energy import costs since 2022 have eroded that, and payments abroad for digital services, from cloud computing to streaming, have grown. The country still earns a large surplus on income from its foreign investments, but much of that is reinvested overseas rather than converted into yen.

A weak yen also spreads through the rest of Asia. Japanese manufacturers compete directly with South Korean and Chinese firms in cars, machinery and electronics, so a cheap yen lets them cut prices abroad or fatten their margins at their rivals' expense, and that puts pressure on the Korean won and the Chinese yuan. Beijing faces the harder dilemma, because it has been trying to keep its currency stable while its own economy struggles with falling prices, and a weaker yuan would help its exporters at the cost of encouraging capital to leave. If China let its currency slide in response, the region could drift into a round of competitive depreciation, with each central bank reluctant to let its exporters lose ground to their neighbours. For now the strength of the dollar is the common factor, and it is dragging most Asian currencies down together, which makes it harder for Tokyo to argue that the yen's weakness is the work of speculators alone.

Tokyo's options

The Ministry of Finance, which controls currency policy, has intervened before. In September and October 2022, with the yen near 146 and then close to 152 per dollar, it sold dollars to buy yen for the first time since 1998. The interventions produced sharp but brief rallies. What eventually turned the yen then was a fall in American yields as inflation peaked, not the intervention itself. Officials have been issuing verbal warnings again, but traders know that intervention works best when fundamentals are already turning.

Winners and losers

A weak yen suits Japan's big exporters, whose overseas profits are worth more when converted home, and the stockmarket, which has reached record highs partly on that effect. Tourism has boomed, as foreign visitors find Japan cheap. The losers are households, who pay more for imported food and energy while wages lag, and smaller firms that depend on imported materials. Foreign investors in Japanese shares who did not hedge the currency have seen much of their gains erased in dollar terms.

What would turn it

The counterargument is that the yen is extremely cheap by most long-run measures and that the turn could come quickly. If the Fed begins cutting rates this year, as its projections suggest, the rate gap would narrow from the American side. A crisis that sent investors rushing out of risky assets would also trigger a scramble to repay yen loans, which pushes the currency up. Both are plausible, but neither is imminent. The indicators to watch are American inflation data, the Fed's June meeting, any further BoJ increases, and whether the ministry follows its warnings with action.

A token rate rise is no match for a 500-basis-point carry spread. The yen will probably keep falling until Tokyo does something serious to narrow the yield gap, and a test of the 152 level that prompted intervention in 2022 looks likely within weeks.