It’s time to talk about the Japanese Yen. Traders may have noticed the violent movements in USDJPY over the last few sessions. Longer term investors may have had the pair on their radar for a while, wondering whether there will ever be a trend reversal. So what’s going on between the Dollar and the Yen?

The crux of the issue is that interest rates on the Dollar are around 5.5%, whereas rates on the Yen are essentially zero. This presents an opportunity, for those in a position to exploit it. The opportunity is known as the carry trade. The carry trade involves borrowing the Japanese Yen at low cost, then investing the borrowed funds into currencies with a higher yield. The spread between the different interest rates dictates the profit margin.

In the case of the Japanese Yen and the United States Dollar, the spread is high enough to warrant a lot of attention in the world of finance. Investment firms borrow the Yen and buy the Dollar, benefitting greatly from the high yield offered by the greenback. This increases the price of the Dollar relative to the Yen, and this has been the main driver behind the surge seen in the USDJPY pair. The problem is that as long as the difference in interest rates persists, so does the selling pressure on the Yen.

But why are the respective interest rates so different in the first place? We need to take a step back in time in order to answer this. Economically speaking, Japan and the USA are in very different situations. The Japanese economy utterly collapsed in the early 1990s, following forty years of extreme growth. The decades of stagnation that ensued forced the Bank of Japan to lower interest rates on the Yen to non-existent levels in order to inject money into their banking system. The framework of monetary easing was designed to stimulate borrowing and investment, encouraging new growth in the beleaguered economy.

The results were mixed. Although the Japanese stock market eventually went on to reach fresh highs, the economy itself never convincingly gained any upwards momentum. This leaves the Bank of Japan with very few options. Any increase in rates will smother what fledgling growth has been achieved so far. The central bank needs to see progress in the form of higher wages, price inflation and economic expansion. So far, the signs are just not there, hence the current target rate of zero.

Now for the United States. The US economy experienced a small recession in 2020. To counteract this, the Federal Reserve lowered interest rates to zero, with the same purpose of stimulating borrowing, investment and growth. It worked. The American economy experienced a strong rebound, so much so that both the labour market and inflation figures started to show signs of overheating. This time, the response was to do the opposite and raise rates until the economy cooled off, hence the current 5.5% target rate.

This is how we arrived at the current situation, but what comes next? At this point, it may be worth reflecting on the consequences of having a weaker currency. Who cares if the Yen declines versus the Dollar? On the one hand, a weaker currency helps tremendously with the export market. Japanese goods become cheaper on the world stage, increasing money inflows into the economy, boosting local growth. A weaker currency also helps to pull in tourists, lured by the attractive exchange rate.

On the other hand, a weaker currency makes everything imported into the country more expensive. This includes very important things, such as oil. For a nation such as Japan, which is entirely reliant on oil imports, this presents a problem. Higher energy costs are obviously very detrimental to industrial production, potentially leading to cost-push inflation, which is what occurs when it becomes more expensive to manufacture goods. Unless the extra growth achieved thanks to higher exports is enough to cover the added expenses of manufacturing the goods, then there is a problem.

What is the Bank of Japan supposed to do? As we said previously, any rate hike would hinder the little economic growth achieved so far. Besides, even if rates on the Yen were allowed to rise to let’s say, one percent, the spread is still high enough to justify the carry trade. The gap would need to be closed considerably, which the BoJ simply cannot do.

Another possibility is for the Bank of Japan to buy the Yen on the open market, selling its foreign reserves in exchange. Judging by the sharp sell-off in USDJPY this week, this may well have already occurred. Changes in the bank’s current account balance appear to be confirming this theory, although markets will have to wait for any official confirmation.

Japan’s problems are exacerbated by the fact that the United States Federal Reserve continues to push interest rate cuts further down the road, meaning the pressure on the Yen is maintained for longer. Not an enviable situation for anyone.

The above explains the situation from the Japanese perspective, but misses something vital. The whole point of the carry trade is to use the cheap Yen to purchase currencies and assets abroad. What happens when this trade unwinds? All that cash will have to be paid back at some point; all the liquidity pumped into foreign assets must be repatriated back to Japan. What happens to the prices of those foreign assets when the time comes to cover the bill? Stock markets around the world beware.

Moreover, returning to the Japanese perspective one last time, what happens to the price of the Yen when the world rushes back into it to repay their loans? Any reversal in trend in USDJPY will trigger a rush to the exits as people sell their foreign reserves to buy back the borrowed Yen. If there is one undeniable truth behind all of this, it is that the world economy has never been more intertwined.