Are positive rates good news for Japanese equities?

In March, the Bank of Japan finally raised interest rates – a seismic event to which the financial press dedicated column miles rather than the usual inches. Readers of not just the Financial Times but also The Mirror and The Mail read about it in the paper.¹ Commentators competed for hyperbole; long-time Japan specialist Jesper Koll heralded the “end of financial socialism”.²

The scale of interest had nothing to do with the magnitude of the move – between just ten and twenty basis points (hundredths of a percent) – but reflected the rarity of the event, it being the BoJ’s first hike in seventeen years, and what it represented as Japan became the world’s last country to ditch negative rates. Still, this was big news, at least by the standards of Japanese monetary policy. Why, then, have markets – for equities, bonds and currencies – largely shrugged it off? Are they right to do so, and if not, what might the ultimate implications be for investors?

Separating the context from the cause

One reason why the change in stance garnered so little immediate market reaction was that it had been so well flagged.  For weeks, the financial press had carried stories about the timing – always when, rather than if – of the BoJ’s departure from NIRP (negative interest rate policy).³  Another is that long-term rates, a better indicator of monetary conditions, had been on the march for some time anyway.

The context for this change in monetary stance, and those which had gone before it, is of course inflation. Japan’s inflationary peak may have been lower and later than the other developed economies, but prices have been rising annually since 2021 or 2022 depending on the measure; a fact remarkable in a country so associated with stagnant prices.  Inflation may be settling down, but it is also broadening out to presumably stickier segments such as services, while wages are also rising.⁴

Note, though, that we say that inflation is the context and not the cause of this shift in monetary conditions.  This is not just semantics.  The cause would be the prime motivation for the policy change, the context is the economic condition which allows it to happen.  For most central banks, inflation is the cause of a monetary tightening – they are inflation fighters. The Bank of Japan is different – it wants to use this period of inflation to normalise policy, not kill it.

The ‘virtuous cycle’

If our choice of words here is important, the BoJ’s is crucial and telling.  In its opening paragraph of its March press release it stated:

“…the Policy Board of the Bank of Japan assessed the virtuous cycle between wages and prices, and judged it came in sight that the price stability target of 2 percent would be achieved in a sustainable and stable manner…” ⁵

The virtuous cycle. Other central bankers talk about the wage-price spiral, usually in grave tones, when explaining why peoples’ mortgages are getting more expensive.  Only the Bank of Japan describes the self-reinforcing relationship between prices and pay as virtuous.  Is this a distinction without a difference?  We don’t think so.  If the BoJ is not adjusting policy to the end of reducing inflation but is rather normalising policy as much as it can before inflation drops below target, then the tightening cycle is likely to be short and shallow.

That is not to say there is nothing more to come from the BoJ, of course.  In his speech last month, Member of the Policy Board Naoki Tamura referred to Japan as “a State without Meaningful Interest Rates” and highlighted why that was a bad thing.⁶ Tamura described his vision of policy normalisation thus:

“In my view, the ultimate goal is, with the price stability target of 2 percent, to return interest rates to a level where they can perform their functions — that is, where raising or lowering interest rates can act to adjust demand and affect prices — and at the same time to recover the hurdle rate function and signalling effects”.

Taking all of this together, it seems to us that far from being the milestone to the beginning of a new monetary regime, the recent hike in Japanese rates is more likely a marker for the beginning of the end of that transition.  Assuming that is the case, let’s turn our attention to what this might mean for markets.

Good news, or bad news, for equities?

Surely this is simple – higher rates are bad for equities, right?  Well, not quite, because if that were true, a cut to rates would always and everywhere be good news for stocks and that is demonstrably not the case.  The last time the Bank of Japan traversed the zero-line with its policy rate, when it cut to negative at the beginning of 2016, the Topix index fell 20 percent in in the following half year.  So dire were Japan’s economic straits that such a novel policy was required, or so went the reasoning at the time.  We think that the rationale can work in the other direction this time round – a bump in policy rate is a vote of confidence, and therefore good news for the equity market.

More interesting to us than the impact on overall market level is the effect at the style and sector level.  Here, once again, history provides a guide.  Let’s cast our mind back to mid-2006 – the last time the Bank of Japan did a “first hike”.⁷ One might have expected that move to presage a period of outperformance for banks, for which higher interest rates are a boon to profits, and underperformance for real estate companies which would be expected to suffer higher funding costs.  The reality, in fact, was the opposite.  Clearly then, it was, as the old cliché goes, better to travel than to arrive.

Finally, we need to consider the implications for currency markets.  We are tentative commentators, at best, when it comes to the Yen but so important is the topic that we must address it.   Over the last few years at least, real interest rate differentials have explained well the direction of the Yen versus the US Dollar.  The inflation fighting Fed has dragged capital away from the Yen, with the dovish BoJ’s assent.

In the event of a resurgence in the Yen, equity investors should expect overseas earners – recent winners including the auto makers and their suppliers – to fall out of favour.  Domestics such as telecoms and other service companies could be the relative beneficiaries.  This eventuality would please us, given that roughly two thirds of position-weighted portfolio revenues are generated domestically.

From NIRP to… PIRP?

Overall, then, we think that the recent move by the Bank of Japan to finally shift its policy rate from NIRP to, err, PIRP⁸ could be meaningful but not in the way one might at first suspect.  It strikes us that this is towards the end rather than the beginning of the BoJ’s to-do list for monetary normalisation.  Normalisation itself could be a boon for the equity market – the opposite was certainly true when NIRP was first adopted.  If the monetary destination is now on this side of the horizon, there is little reason to think that it is much short of fully priced in.  In which case, the market’s love affair with value and especially the most interest sensitive sectors such as banks could be coming to an end.  The weak Yen has been the bane of unhedged investors lives over the last few years, and here at least as much will depend upon what happens in the US and elsewhere as it does events in Japan.  Still, recent moves have pushed the Yen to levels of cheapness which seem out of whack with reality; a snap-back could reverse attention away from much loved exporters and towards domestic earners.  None of this would displease us.

¹ Bank of Japan ends negative interest rate policy, opting for first hike in 17 years – Mirror Online Japan raises its benchmark borrowing rate for the first time in 17 years | This is Money
² Bank of Japan rate hike signals end of financial socialism – OMFIF
³ BOJ to end negative rates, marking 1st hike in 17 years – Nikkei Asia
⁴ ko240403a1.pdf (boj.or.jp)
⁵ k240319a.pdf (boj.or.jp)
⁶ ko240403a1.pdf (boj.or.jp)
⁷ The BoJ hiked again in 2007.  NB: following the BoJ’s first hike, the Topix index rose for the next several months in a mirror image to the 2016 experience mentioned above.
⁸ Such is the normality of positive interest rates, that condition does not seem to have its own accepted acronym

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