The Bank of Japan’s decision to raise interest rates this morning (19 March) is “extremely significant” for both Japan and global markets, according to industry commentators, despite the well-communicated move receiving a muted reaction from markets.
Following a 7-2 majority vote, Japan’s interest rate will now stand between zero and 0.1%, compared to minus 0.1% previously. It had been negative for more than seven years before today’s decision, with Japan the last major central bank to begin unwinding its ultra-loose monetary policy.
David Mitchinson, fund manager at Zennor Asset Management, said the hike had come in the wake of Japan’s “first steps to sustainable real wage growth”, with data showing wages growing at levels “not seen for 30 years”.
“The move [to raise rates] may not be a surprise, but it is an extremely significant event for Japan and world markets,” he explained. “The key questions now for the Bank of Japan are the sustainability of price rises and real wage growth. It is painfully aware that overly aggressive policy tightening in the past has stopped economic recovery and returned Japan to disinflation.”
Mitchinson added the Bank of Japan’s main focus now would be to manage the pace of tightening, in order to prevent market panic and currency volatility.
“[The Bank’s] view on Japanese inflation expectations is backwards-looking and responds only slowly to recent price data,” he pointed out. “This modelling suggests the Bank of Japan may have more scope to be behind the curve than many central banks in the west. Markets have already priced this positive development into the short-term rate curve and implied FX pricing shows elevated volatility priced in. This suggests investors have anticipated both an exit from negative interest rates and prepared for potential yen strength.”
Current account ramifications
Naomi Fink, global strategist and managing director at Nikko Asset Management, said investors should now pay attention to Japan’s current account, which had previously been benefitting from ultra-low rates.
“The main contribution to Japan’s external surplus is now the income account, as one might expect from a country with lower rates than elsewhere in the world,” she said. “This composition explains why the yen remains on the historically weak side. It remains to be seen whether the ramifications of the termination of the world’s last negative rate regime may be felt elsewhere.
“For now, with the Bank of Japan reluctant to signal further policy tightening, markets do not appear ready to give up on the ‘carry trade’ just yet. Immediately after the decision, the yen remained under pressure – one sign that it is still being used to purchase higher-yielding overseas assets.”
Despite potential headwinds, Mitchinson said Japan’s exit from negative rates would help to combat long-running deflation,” adding: “This is a structural change that is very important for Japan and for global capital market flows. The US, for instance, has been able to rely on large Japanese surplus savings to fund the deficit. With rates in Japan now rising and with elevated hedging costs, this is increasingly unattractive. Will these flows reverse? What will the impact be on US rates?”
Good news for small-caps?
For Japanese small caps, meanwhile, Alan Rowsell, lead fund manager of the Premier Miton Global Smaller Companies fund, said the rate rise was inherently positive.
“While the move was well communicated by the Bank of Japan and anticipated by the market – hence the muted reaction – it is another step along the pathway towards sustainable low inflation and economic growth, ending decades of deflation.
“Small caps tend to do better when the economy is strengthening, and today’s news is a sign that the Bank of Japan thinks the Japanese economy is stronger and no longer needs life support.”
He added: “The bank also announced it would stop buying ETFs and J-REITs – a policy that tends to benefit large caps disproportionately. After several years of underperformance and valuations close to multi-year lows, I would expect to see a rotation back into small caps on this news.”
