Market participants are bracing for an unexpected — and for a long time, unthinkable — interest rate hike by the Bank of Japan (BoJ). In an interview on Saturday, BoJ Governor Kazuo Ueda indicated that he is considering raising rates “provided wages and prices continue to rise sustainably.”
Such a move would mark a significant shift in the BoJ’s yield curve control policy. Since 2016, the central bank has maintained a negative interest rate and kept long-term rates below 0.5% in an effort to boost the economy and combat persistent deflation. Those efforts appear to have paid off: Japan’s GDP is growing faster than expected and inflation is at 3.3%.
SP500 Index vs. Nikkei 225 Index
As a result of Ueda’s hawkish tone, the yield on a 10-year Japanese government bond is now at 0.7%, the highest in a decade. Another concern is that equity investors fear the historic rally of the Nikkei 225 may finally be coming to an end.
“A tighter monetary policy coupled with a stronger yen implies a weaker stock market going forward,” said Joost van Leenders, investment strategist at Van Lanschot Kempen. Simon Wiersma, investment manager and strategist at ING, also expects higher rates, and thus “more headwinds” for Japanese equities.
This year, the Japanese stock index has outperformed the S&P 500, rising more than 27% from its level at the beginning of 2023. However, it has been flat since peaking in June, seeking direction.
Valuations historically tend to rise
Those who zoom out on the performance of the Japanese stock market will see that long-term interest rates have been moving upward alongside stock valuations since 2016 when the BoJ initiated its yield curve control.
“It’s historically more likely that stock valuations rise rather than fall when interest rates increase from low levels, as is the case globally this year,” said Ruch Kustrich, portfolio manager at BlackRock’s Global Allocation Fund, in a note.
This trend has also been observed in the U.S. since 1995. In months where the yield on the U.S. 10-year Treasury bond rose more than 50 basis points, the S&P 500 increased by 3.2% in the subsequent three months — about 100 basis points more than in a typical month.
“Although it’s unlikely that the actual market movement will precisely align with the model, the relationship shows that real interest rates and stock prices generally move together,” Kustrich added.
Investors show interest
Meanwhile, banks like Goldman Sachs Group and JPMorgan Chase report receiving “increasing numbers of calls and emails from clients interested in investing in Japan,” according to The Wall Street Journal.
Maya Funaki, portfolio manager at RBC Bluebay AM, is also optimistic. “The general normalisation of Japan’s domestic economy, and ‘breaking the long-term deflation,’ should be viewed as positive for both market sentiment and corporate earnings growth,” she told Investment Officer. She expects a rise in stock prices.
Rates could weigh on valuations
Dutch strategists from ING and Van Lanschot Kempen remain less convinced of the upside potential for the Japanese stock market.
“Contrary to what some claim, economic activity in Japan is actually declining, and inflation seems to have already peaked,” Wiersma noted. “In this scenario, higher rates are indeed a strong headwind for Japanese equities. Growth in the second quarter was entirely driven by exports.”
Van Leenders is also sceptical. “Stocks can usually withstand higher rates,” he said, “but if inflation becomes too high and rates have to significantly rise, that will eventually weigh on valuations, as happened globally in 2022.” The question remains whether significant monetary tightening is necessary in Japan, van Leenders admitted.
This article originally appeared in Dutch on InvestmentOfficer.nl.