End of an Era: Japan Exits Negative Rates

The Bank of Japan (BOJ) has moved its policy rate above zero and increased interest rates for the first time in 17 years. This is a significant moment for both financial markets and the global economy as the BOJ was the last major central bank to exit negative-rate policy.

Although the BOJ will maintain its policy of buying around ¥6trn a month of Japanese government bonds, the central bank has abandoned its policy of yield curve control (intervening in markets to keep the 10-year government bond yield below 1%) and has stopped purchasing exchange-traded funds and real estate investment trusts.

The BOJ has been trailing its interest rate hike in advance of the meeting and, as such, the immediate market reaction was muted (Japanese government bond yields and the yen actually fell), however this historic shift adds further weight to our positive outlook for Japanese equities.

Japanese monetary policy remains highly accommodative, and Governor Kazuo Ueda has made it clear that these conditions “will be maintained for the time being”. After decades of ultra-low inflation, we do not expect that the BOJ will do anything that will jeopardise their goal of moving inflation sustainably towards 2%. Although we are mindful of the impact that a stronger yen can have on Japanese stocks, we do not expect that the shift to marginally positive rates will trigger a sharp rally in the currency. It is also important to note that Japanese corporate earnings are being driven by other factors than just yen weakness, and overseas investors (investing in other currencies) actually benefit from yen strength.

More broadly, the economic backdrop in Japan remains positive. Recent annual union wage negotiations resulted in pay gains in excess of 5%, the biggest rise since the start of the 1990s. The shunto pay negotiations have been closely followed by investors this year as robust wage growth was seen as essential for the BOJ to shift away from negative rates. The BOJ has concluded that the economy is in a “virtuous cycle” between wages and prices, meaning that wages are rising enough to cover increasing prices but not so much as to cut into business profits.

As we have written about recently, corporate reforms in Japan have resulted in better managed and more profitable companies. This has unlocked some of the significant value embedded in Japanese businesses and we expect that this trend will persist for the foreseeable future as the Tokyo Stock Exchange continues to pressure companies to improve their capital efficiency and return on equity. The directive by the Japanese bourse for companies trading below book value to come up with capital improvement plans has had significant positive implications for shareholder returns.

Looking forward, we believe that the normalisation of monetary policy is another crucial milestone in Japan’s journey away from decades of disinflation and underwhelming stock market returns. We maintain our overweight position in client portfolios.