Japan's Monetary Policy Shift: From Negative Rates to Normalization, How Investors Can Navigate the New Market Trends

On March 19th, the Bank of Japan announced that it would raise its benchmark interest rate from -0.1% to 0-0.1%, marking the first interest rate hike by the central bank since 2007 and officially ending the eight-year era of negative interest rates. However, Japan's ultra-loose monetary policy era has roots dating back much earlier, with a fascinating investment narrative throughout this period.

In the early 1990s, Japan experienced a severe asset price bubble, particularly in real estate and the stock market. The aftermath saw banks saddled with massive non-performing loans, and both corporate and household sectors heavily indebted, severely affecting credit supply and real economic activities. Subsequently, Japan entered a prolonged period of deflation, where the overall price level continuously decreased, leading consumers and businesses to expect even lower prices in the future, thus postponing consumption and investment, further stifling economic growth.

Since April 13, 1992, in the Japanese animated series "Crayon Shin-chan" broadcast on TV Asahi in Japan, the main focus has been on the everyday life of the Nohara family from Crayon Shin-chan. At that time, there was even an episode where a character referred to as the "Deflation Monster" appeared in the show, and Shin-chan's mother, Misae Nohara, began cutting expenses by purchasing more discounted items.

In the context of the ongoing domestic economic downturn, rising unemployment, and sluggish domestic demand, the government and the central bank aimed to stimulate consumption and investment through lowering interest rates to boost economic growth. However, when traditional monetary policy tools like short-term interest rates neared the zero lower bound (known as the "zero-interest-rate policy"), conventional rate cuts could no longer effectively stimulate the economy. In this backdrop, the Bank of Japan adopted unconventional and non-standard quantitative easing policies to inject more liquidity into the markets.

The ultra-loose monetary policy reached its zenith during the Abe administration, known as "Abenomics," which consisted of three arrows.

chart: Japanese Policy Rate

Abenomics sought to break the vicious cycle of the economy and revitalize the Japanese economy while restoring market confidence through a combination of monetary policy, fiscal policy, and structural reforms. Let's delve into how these three arrows were deployed.

The first arrow of Abenomics involved bold reform of monetary policy, requiring the Bank of Japan to implement super loose monetary policy by purchasing large quantities of government bonds and other financial assets, significantly increasing the base money supply with the goal of achieving a 2% inflation rate. The rationale was that by increasing liquidity in the markets, lowering long-term interest rates, encouraging borrowing by corporations and individuals, stimulating investment and consumption, and thereby pushing up price levels, the policy aimed to break the deflationary expectations.

Through implementing fiscal stimulus measures such as public works investments, tax cuts, and other fiscal spending programs, the second arrow directly aimed to boost domestic demand, create job opportunities, especially in infrastructure development. The logic behind fiscal policy was to temporarily utilize government spending to fill the gap in private sector demand, thus stimulating economic growth.

The third arrow encompassed a wide range of structural reforms and growth strategies, including promoting female labor force participation, reforming the labor market, enhancing corporate governance, advancing negotiations for free trade agreements like TPP, and deregulation to encourage corporate innovation and competitiveness. The reasoning behind structural reforms was to achieve sustainable long-term economic growth by improving economic efficiency, boosting corporate vitality, and enhancing international competitiveness.

However, over time, this policy mix faced numerous challenges, such as the potential for increased debt burdens due to overreliance on monetary policy, and the difficulty of implementing structural reforms, which often take considerable time to show results.

Moreover, with changes in the global economic environment, particularly adjustments in monetary policies of other countries and regions, the effectiveness of structural reforms under Abenomics remains a subject of consideration. A notable feature of Abenomics was the push to weaken the yen to promote exports, but this also meant that when foreign currencies are converted into yen, Japan's GDP measured in US dollars might appear smaller, causing Japan's dollar-denominated per capita GDP to trend downward.

chart: Japan's Per Capita GDP in US Dollar Terms

Since Shinzo Abe proposed and implemented this series of economic policies at the end of 2012, Japan's per capita GDP denominated in US dollars has seen an overall decline, especially a more pronounced drop after the pandemic. However, during this period, the Nikkei 225 Index and other major stock indices have experienced significant growth, particularly in the early stages when the market had high expectations for the monetary easing and fiscal stimulus brought about by Abenomics. Investor confidence was boosted, leading to a surge of capital inflows into the stock market, which pushed up stock prices. The Nikkei 225 index roughly tripled since the inception of Abenomics, showcasing substantial gains.

The stock market's performance can be attributed to the Bank of Japan's massive quantitative easing policy, which increased market liquidity, lowered long-term interest rates, and reduced corporate financing costs, thereby enhancing corporate profitability and making stocks more attractive from a valuation perspective. Furthermore, the government's increased public spending stimulated domestic demand, positively impacting corporate earnings and supporting stock prices.

Market optimism regarding the potential of Abenomics to end deflation and revitalize the economy was strong, driving stock market growth. Now that Japan is moving away from negative interest rates, how significant will the impact be?

With Japan ending its negative interest rate policy, concerns arise that the termination of such a policy may trigger worries over market liquidity, possibly causing a short-term correction in the stock market, particularly affecting sectors and companies that thrived under low-interest-rate conditions. Nevertheless, one perspective suggests that even if Japan exits negative rates, the magnitude of the shift might not be overly drastic: Japan's debt situation.

Japan's government debt ratio is extremely high, consistently ranking among the world's highest, with a debt-to-GDP ratio exceeding 200% as of 2023. This high level of debt reflects the accumulation of massive borrowings due to prolonged efforts to stimulate the economy through fiscal stimulus measures and address the social security pressures arising from an aging population.

It is noteworthy that the majority (over 90%) of Japanese government bonds are held domestically, by entities like private banks, insurance companies, pension funds, and individual investors rather than foreign investors. This implies that as long as the interest rate on debt remains manageable, from a long-term standpoint, "domestic debt is not really debt." Hence, the reason why following a rate hike, the Nikkei did not fall but rose could be explained by market participants betting that future rate hikes would not be particularly aggressive. On March 19th, the Bank of Japan announced it would raise the benchmark interest rate from -0.1% to 0-0.1%, which indeed confirmed this logic, leading to the Nikkei 225 climbing while the yen weakened.

However, looking at a longer investment horizon, given Japan's immense debt burden, until it achieves significant progress in industrial structure upgrades, the country is likely to maintain a relatively loose monetary policy. Moreover, Japan's inflation rate has remained above 2% for the past two years, breaking the decades-long deflationary trend. Investors can assess future investments in the Japanese index from two dimensions: "economic fundamentals" and "the path of rising interest rates."

Scenario 1: In a context where economic fundamentals are robust and interest rates rise moderately, if the market anticipates sustained healthy economic development, the stock market may rise because investors would be willing to bear slightly higher financing costs in exchange for potential increases in corporate earnings driven by economic growth.

Scenario 2: Conversely, if economic fundamentals weaken while interest rates are on the rise, this could accelerate a stock market downturn as investors fear that under uncertain economic prospects, declining corporate profits coupled with higher debt costs would severely erode corporate value.

For investors considering investing in Japanese stocks amidst the end of the negative interest rate era, it becomes increasingly crucial to monitor Japan's economic fundamentals closely and base their investment decisions on these "economic fundamentals" and the "trajectory of interest rate hikes."

While the dollar-denominated per capita GDP did indeed experience a decline, it is noteworthy that following the implementation of Abenomics, Japan's stock market generally exhibited a distinct upward trend.

Disclaimer: Moomoo is a financial information and trading app offered by Moomoo Technologies Inc. In the U.S., investment products and services available through the moomoo app are offered by Moomoo Financial Inc., a broker-dealer registered with the U.S. Securities and Exchange Commission (SEC). In Singapore, investment products and services available through the moomoo app are offered through Moomoo Financial Singapore Pte. Ltd. regulated by the Monetary Authority of Singapore (MAS). This advertisement has not been reviewed by the Monetary Authority of Singapore. In Australia, financial products, and services available through the moomoo app are provided by Futu Securities (Australia) Ltd, an Australian Financial Services Licensee (AFSL No. 224663) regulated by the Australian Securities and Investment Commission (ASIC). In Canada, order-execution only services available through the moomoo app are provided by Moomoo Financial Canada Inc., regulated by the Canadian Investment Regulatory Organization (CIRO).[JL1]

[JL1]I updated