SINGAPORE: Barely a few weeks after Japanese stocks broke three-decade highs, the country's financial markets are racing towards another phenomenon not seen in almost a generation: rising interest rates.
Bankers are taking tutoring courses on what to do when interest rates change, and trading floors are being set up to help moribund derivatives markets come back to life – as they already have.
Their pricing implies that it will take a few months at most for the last bastion of a decades-long monetary policy experiment with negative short-term interest rates to fall. A Bank of Japan exit is expected in June, with an even chance of interest rates rising to zero next week.
Such a 10-basis-point rise would be small, leaving traders to focus on broader signals: whether a change will be implemented immediately or later, and whether the BOJ will halt its huge asset-buying program of everything from Japanese government bonds to listed equity funds.
The symbolism is also heavy as Japan seeks to put behind it “lost” years marked by deflation and revitalize the world's fourth-largest economy as a destination for investment – a shift that is already impacting Japanese businesses and global ones has markets.
“I personally believe this will be the beginning of a new era,” said Keita Matsumoto, head of sales and solutions for financial institutions at Citigroup Global Markets Japan.
“It's a fundamental shift in the way people think,” he said, which could take five or 10 years given the economic changes.
Some of the biggest impacts could be on Japan's 1.3 quadrillion yen ($8.7 trillion) government bond market.
Matsumoto said investors were preparing to profit from selling short-term paper as a rise in central bank deposit rates would quickly drain banks' capital from bonds into cash.
If a major policy shift leads to a significant rise in longer-term interest rates, Japanese investors – which own around $2.2 trillion in foreign debt – could also lose their appetite for securities closer to home, which is what global bond markets are seeing would burden
The foreign exchange market has seen a bit of a reversal in recent days in a market where the yen is heavily short and is having to prepare to pay interest, albeit low, on the Japanese currency.
Equity investors have been buying bank stocks on bets that loans will rise and margins will expand, although trading has become jittery in recent days as the possible policy change approaches.
The Nikkei, which hit a record high above 40,000 last week, posted its biggest fall in five months on Monday.
“There has been a fair amount of excitement about the Japanese economy and monetary policy… becoming more 'normal' and similar to other countries,” said Niraj Athavle, head of sales and marketing at JP Morgan in Singapore.
“Due to the fact that the Japanese are getting out of deflation for good, the stock market is starting to attract a lot of attention – bond markets and swap markets will follow as Japan tends to move towards a more normal economy.”
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Previous migration cycles in Japan took place under such different circumstances that comparisons are difficult.
In 1989 and 1990, interest rates were raised by more than 300 basis points, bursting a housing bubble and crippling the economy and stock market for a decade. In 2006, an attempt to end the zero interest rate policy failed because inflation could not be maintained.
This time, both investors and policymakers point to higher wages and changing corporate attitudes as new elements. Wage negotiations data due on Friday before the BOJ meeting could move markets, especially if it surprises positively.
“Markets are still underestimating any long-term changes in Japan,” said Ales Koutny, head of international rates at Vanguard, who is increasing his short exposure to Japanese government bonds.
“A wage number high enough to support consumption could draw attention to a possible longer rate hike cycle.”
He sees the five- to 10-year maturities as most vulnerable if the BOJ withdraws support, saying 10-year Treasury yields could exceed 1 percent and, over the longer term, could trade like German Bunds, which yield 2.3 percent. when wages, consumption and inflation begin to reinforce each other.
Japanese two-year yields, which reflect short-term interest rate expectations, have hit a 13-year high of 0.2 percent, while five-year and 10-year yields are near multi-month highs of 0.4 percent and 0.77 percent, respectively.
After near its lowest level on record in real terms, the yen rose 2 percent last week, posting its biggest weekly rise against the dollar in eight months, as short sellers fell slightly.
Of course, emerging from such a long period of unorthodox policy is difficult and it will take a long time for the distortions in the economy to dissipate. Smaller companies in particular face challenges due to higher credit costs.
Overcrowded bets on bank stocks are vulnerable to being able to “sell” losses in the event of a policy change, said Naka Matsuzawa, Japan macro strategist at Nomura. The BOJ's refusal to buy equity funds as markets fell this week has already unsettled some investors.
A yen rally to 135 or 130 against the dollar could also trigger a global response, investors said, as it would likely result in yen-funded carry trades being unwound.
But at 147 per dollar on Wednesday, that is still a long way off and most see a temporary return of animal sentiment in Japan as positive.
“In 2024, Japan does not have an overheated real estate market nor is the country in deflation,” said Byron Gill, managing partner at Indus Capital Partners in San Francisco, with real interest rates – the nominal interest rate less inflation – likely to remain below zero become.
“If at the same time wage growth can exceed the inflation rate,” he said. “Japan could be in a real welfare region for both the economy and risk assets.”
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