Bank of Japan puts global market needs above its own priorities

The Bank of Japan (BOJ) is rethinking its plans to raise interest rates after last week’s hike triggered a “Black Monday” crash in global stocks.

Earlier this week, BOJ Deputy Governor Shinichi Uchida said the central bank has no intention to stoke market volatility and will adjust its interest-rate strategy to avoid causing instability.

“[T]he bank will not raise its policy interest rates when financial and capital markets are unstable,” Uchida said, as reported by The Wall Street Journal.

Uchida added that the BOJ is monitoring developments in the stock and currency markets “and their impact on economic activity and prices with utmost vigilance.”

“As we’re seeing sharp volatility in domestic and overseas financial markets, it’s necessary to maintain current levels of monetary easing for the time being,” he said.

The comments were a major U-turn from just a week earlier when the BOJ hiked interest rates for only the second time in 17 years. At the time, Governor Kazuo Uedo said he wanted to keep raising rates to combat inflation and a weakening yen.

Uedo’s comments came amid growing expectations that the Fed will soon begin lowering interest rates. Following the last Fed meeting hinting at a September cut, Japan’s Nikkei plunged 12.4%, the largest single-day drop since 1987.

U.S. stocks followed suit, posting their biggest one-day drop since the Covid crash.

Overreaction or expected reaction?

The BOJ’s rate hike was small on the surface—from 0.1% to 0.25%—but it had an oversized reaction as the yen strengthened against the U.S. dollar.

Expectations of additional rate hikes led many pundits to declare the end of the so-called yen carry trade.

The yen carry trade is a strategy that involves borrowing the yen at low interest rates and using it to buy currencies and other assets that generate higher yields.

As Reuters reported, the yen carry trade typically nets investors 5% to 6% on an annualized basis, which represents the difference between U.S. and Japanese interest rates.

“You can’t unwind the biggest carry trade the world has ever seen without breaking a few heads,” said Kit Juckes, a currency strategist at Société Générale.

Although estimates vary, analysts say the cumulative size of the dollar-yen carry trade is probably in the north of $500 billion.

An unnamed Japanese official told the Financial Times, “There was a lot of irrational use of the carry trade over recent years, so it was inevitable that there would be a very big unwinding of that at some stage.”

Although markets have responded positively to the BOJ’s reassurances in recent days, analysts say the unwinding of the yen carry trade can still threaten the global financial system.

According to JPMorgan currency strategy Benjamin Shatil, one problem is that nobody knows for sure how big the yen carry trade is. In his view, the threat has likely been reduced, but it “still has some way to go.”