While the Japanese economy is improving and we are on the verge of moving from negative to positive interest rates, there are still many challenges ahead. We know the Bank of Japan is on the brink of increasing interest rates for the first time since 2006, but they need to appreciate the broader repercussions.
Will interest rates move from negative to positive?
The Japanese central bank interest rate currently stands at -0.1%, although there is intense speculation that it will soon rise by 0.2% to 0.1%. While these may seem relatively modest figures, they indicate a new era for the Japanese economy, population and investment markets. It is believed that such a move would lead to money market rates recalibrating to between 0% and 0.1%.
A three-tier system with interest rates
Interestingly, when interest rates were negative, the Bank of Japan (the central bank) ran a three-tier system for interest rates. Much of this was focused on Japanese banks, protecting bank earnings to an extent and a means of encouraging them to trade on interbank markets. If Japanese banks had not been trading on interbank markets, liquidity would have fallen, and rates would have been impacted.
Many market observers believe that going forward we will see a two-tier system, similar to the Swiss central bank before 2022, to prevent a reduction in interbank trading. Time will tell!
Bank of Japan bond portfolio
As a means of supporting money markets and the economy, over the years, the Bank of Japan has built up a considerable bond portfolio. This will need to be reduced at some point, but now may not be the time. Instead, the authorities believe that uneven bond maturity dates will allow them to reduce the portfolio by around $470 billion a year while reinvesting slightly less into new bonds.
The net result would be a gradual reduction in the bond portfolio and a move towards more free-market policies. However, if the redemptions run just slightly higher than reinvestment, this could take some time!
How quickly might interest rates rise?
As we have covered in recent articles, opinion is divided as to how quickly Japanese interest rates will rise. Some believe that an increase to 0.1% would be maintained until 2025, while others expect a rise to 0.25% by July this year. It's also important to consider that any significant increase in interest rates would impact the Japanese population's debt repayments.
We also know that many of Japan's largest corporations are ready to increase wages later this year, which it is hoped will be followed by small to medium-sized companies. A period of wage growth would likely bring forward any further increases in interest rates, with inflation easing and household consumption expected to improve.
Summary
For years, investment markets have been looking towards the Japanese central bank amid hopes that interest rates would eventually move back into positive territory. Now we are nearly there; there needs to be more clarity about the size of the first increase and the potential impact on money markets. As we touched on above, there are several factors to consider, meaning we are more likely to see a relatively slow approach by the Bank of Japan.