Until recently, decades of quantitative easing, negative interest rates, and yield curve control have had little effect in jolting Japan’s economy out of its doldrums. Minimal price growth and even deflation were symptomatic of this malaise.
“Japanese restaurants were still using menus from the 1980s and ‘90s because there were no changes in prices,” said Ales Koutny, head of international rates in Vanguard Fixed Income Group.
But the paradigm in Japan is changing, and that resigned mindset is being upended. Japan’s central bank may go further in its rate-hiking campaign that it started earlier this year, and the recent change in the nation’s prime minister will likely not stop that momentum.
“If anything, the new prime minister, Shigeru Ishiba, seems more supportive of the Bank of Japan’s new direction than his predecessor,” said Grant Feng, a Vanguard senior economist who studies the Asia-Pacific region.
Importing inflation
The COVID-19 pandemic and the war in Ukraine may have provided the impetus to get Japan out of deflation and into modest growth.
“Japan imported inflation,” Feng said. “The price shocks from imported commodities and energy have seeped into wages, resulting in Japan’s first real wage growth in more than two years. Now, that wage growth is feeding into broader core inflation, and inflation expectations have increased. For a country that had been stagnant for so long, it’s a virtuous cycle.”
Higher wages feeding into broader inflation in Japan
Notes: The chart shows the statistical coefficient measuring the sensitivity of inflation to changes in wage growth. For core inflation, we use the Bank of Japan’s preferred core inflation measure, which excludes volatile energy and fresh food prices.
Sources: Vanguard calculations using data as of March 31, 2024, from CEIC, the Ministry of Internal Affairs and Communications, and the Ministry of Health, Labour and Welfare.
The rebound in prices doesn’t appear to be just another false start, Feng said. “Private consumption is now driving demand as real wage growth turns positive, suggesting a true structural change is more likely than a one-off shock. And, with Japan’s shrinking and aging population, upward pressure on wage growth will continue.”
Large Japanese companies are expected to increase wages by more than 5% this year after annual wage negotiations. “Japanese consumers have among the highest savings rates in the world,” Koutny said, “But they, too, will spend if they have surplus wages. In addition, inflation on the services side is stickier, so this is more of a permanent change.”
Rising rates likely ahead
With inflation rising, the Bank of Japan (BOJ) ended its negative interest policy earlier this year, modestly raising rates while easing back its monthly bond-buying program.
“The BOJ will likely continue to normalize its monetary policy, albeit cautiously,” Feng said. BOJ policy will depend not just on inflation but also on the currency exchange rate and the state of the capital markets. If the yen weakens relative to the U.S. dollar and the capital markets are stable, more rate hikes are likely. If the yen strengthens too sharply or the markets become too turbulent, the BOJ will likely reduce the pace of rate hikes or cease them altogether.
Vanguard’s baseline forecast is for an additional policy rate increase of 25 basis points this year, with two more quarter-point hikes in 2025. This is contrary to the view of markets, which are pricing in smaller rate increases.
Yen may get closer to fair value
“According to our proprietary model, the fundamentals of the long-term relationship between the yen and the U.S. dollar have remained stable,” said Ian Kresnak, a Vanguard investment strategist. “Cyclical fluctuations have been a result of actions by central banks on both sides of the Pacific. Those fluctuations should normalize as policy normalizes from opposite ends of the spectrum.”
Yen likely to return toward fair value as policy rates converge
Notes: The fair-value range is Vanguard’s fair-value estimate plus or minus half a standard deviation. Our fair-value estimate is a proprietary measure that compares the U.S. dollar with a range of developed markets currencies (in this case the Japanese yen). The fair-value estimate is based on the portion of exchange rate movements that can be explained through differentials in relative economic strength, measured by productivity (GDP per capita at purchasing power parity) and long-term real rates.
Sources: Vanguard calculations using data as of March 31, 2024, from Refinitiv and the International Monetary Fund. Actual exchange rates are through August 31, 2024.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of March 31, 2024. Results from the model may vary with each use and over time. For more information, please see the Notes section below.
In terms of monetary cycles, Japan today is where the U.S. and most developed markets were two years ago, said Koutny. With the BOJ hiking rates and the Federal Reserve cutting, the difference between Japanese and U.S. interest rates will decrease, likely causing the yen to strengthen against the dollar. Currently the yield curve is steeper in Japan than in the U.S. We would expect the U.S. yield curve to steepen as the Fed continues to cut rates and the Japanese yield curve to flatten as the BOJ raises rates.
A more attractive Japanese market
The structural changes in Japan go beyond the impact on yield curves and currencies. In the past, surprise interest rate moves by the BOJ made Japan’s fixed income market unattractive for foreign investors. Furthermore, the BOJ owns the majority of Japanese government bonds (JGBs), creating an environment where prices and yields do not reflect true market forces. But the BOJ has recently moved toward greater transparency, signaling its interest rate moves in advance. And, while the BOJ still owns 55% of JGBs, it has eased back on ownership of those bonds, increasing the odds of the yen converging to fair value.
The takeaway for investors is that a market that was easy to ignore in recent decades because of economic stagnation and the BOJ’s bond market dominance now appears to be a potential source of alpha. “For better or worse, Japan has become far more interesting for investors,” Koutny said, “with market forces playing more of a hand.”
“In light of these shifts, investors may want to consider their long-term asset allocation strategies,” Kresnak said. “A stronger yen would strengthen returns from Japanese equities for a U.S. investor. Fixed income is a little more complicated. Higher interest rates would lead to greater volatility in the short- and medium-term—something a strengthening yen could help offset. However, longer term, higher yields bode well for future returns, reaffirming the role of Japanese bonds in globally diversified portfolios.”
Notes: All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Investments in bonds are subject to interest rate, credit, and inflation risk.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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