This week, we turn to the curious case of Japan. After almost 25 years of anemic growth, strong deflationary pressures, a rapidly aging population, negative interest rates and huge fiscal deficits, in this topsy-turvy world of global finance the Japanese yen is now the best-performing currency against the U.S. dollar in the last four months – appreciating by about 12 percent. 

Moreover, Japan, along with Switzerland, has the deepest and most protracted negative bond yields in the world and yet both countries' currencies act as safe haven currencies every time there is financial turbulence in the market. Yields of Japanese Government Bonds (JGB) are now negative out to 10 years and the 15-year yield is skating just above zero. 

So why does anyone buy the JGB?

First, there is the Bank of Japan (BOJ) itself. It needs to continue to buy JPY securities as part of its expansionary asset purchase (“quantitative easing”) monetary policy. Consequently, the BOJ now owns more than a third of all outstanding bonds. And then there is the Japanese investment community, i.e. insurance companies, pension funds and banks. They own these bonds because there is a restriction on how much they can hold in foreign securities.  

Basically, JGBs are held by the Japanese themselves and they have a continuous need to keep buying them as long as there is no monetary tightening possibility – something that hasn’t happened in 25 years and doesn’t appear likely any time soon.

Given this unusual situation, some feel that there may be more capital gain opportunities in buying JGBs, on a short-term basis, than in buying U.S. treasuries. After all, U.S. bonds could start selling off as soon as the Fed turns hawkish.

Clearly, this is where market economics start getting a bit distorted.

The question remains, however: Why is the yen so strong? The fundamentals certainly don’t argue for it. But what has happened over the last few months started with lower rate expectations in the U.S., leading to U.S. dollar weakness. Couple that with investors who took short yen positions and got caught on the wrong foot, forcing them to unwind their positions as the dollar spiraled downward.

Our view: Japan is in a real box. Monetary policy tools have been exhausted and, like pretty much everywhere else in the world, structural reforms are needed. Until that happens, Japan’s back will remain against the wall.

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