Japan’s Crisis Is Becoming a Global Problem

Hi, welcome back to the channel. In today's episode I want to talk about what's happening in Japan because I think this has potentially huge implications not just for Japan but also for the United States, Europe and the wider global economy because something strange has just happened. The Bank of Japan has raised interest rates to their highest level in 31 years. Now normally when a central bank raises interest rates its currency strengthens but that is not what's happened. The yen has weakened again and it's now trading at around 157 yen to one US dollar. So Japan has raised interest rates, the Bank of Japan has become more aggressive, the government has already intervened in the currency markets, the United States has even previously joined Japan in supporting the yen and yet the currency is still struggling and that tells us something very important. The market does not think Japan has done enough and if that continues the consequences could spread well beyond Japan because this is not simply a story about tourists getting more yen for their dollars. Japan sits right at the heart of the global financial system. Japanese investors own enormous quantities of overseas assets, Japanese banks have lent money all around the world, the yen has been one of the most important funding currencies for investors for decades and Japan is one of the largest advanced economies on the planet. So when Japan starts changing interest rates after decades of ultra cheap money the effects can be felt in New York, London, Frankfurt and just about every major financial market and to understand why this matters we need to start with the yen. Now just before we get started on all of that could I ask anybody that hasn't subscribed yet to please hit that red subscribe button. Don't worry it's not a subscription you're not giving me any money it just says you quite like these sort of videos and you can also give me a thumbs up for this video and potentially hit that hype symbol if you can see it's like a diamond shape or a shooting star or a bell depending on what country you're in it will help promote this video to more people. To have a look at this graph you can see just how extraordinary the moves in the exchange rate between the yen and the US dollar have been. Earlier this year the yen weakened to around 164 against the US dollar which was its weakest level in around 40 years. Japan and the United States then stepped into the market and the yen strengthened sharply at one point it moved around to 155 against the dollar. Then as markets started expecting the Bank of Japan to raise interest rates more aggressively the yen strengthened again but now look at what's happened. Despite the Bank of Japan actually raising rates to 1.25 percent the currency has fallen back towards 157 and that's the key point here. The Bank of Japan has taken action but the currency market is effectively saying we don't think you've done enough and the reason comes down to interest rate differentials. Japan's interest rate is now 1.25 percent and that sounds high by Japanese standards but globally it's relatively low. US interest rates remain substantially higher than they are in Japan and rates in a number of other major economies are also much higher multiples of 1.25 and that creates an incentive to have something called the carry trade and this is where investors borrow money in a low interest rate currency like the yen and then invest that money somewhere offering a higher return. So you borrow cheaply in Japan you convert the money into dollars and then you might buy US government bonds, corporate debt, shares or other assets. As long as the yen remains relatively weak and the return you earn elsewhere is higher than the interest you're paying in Japan the trade can be very attractive and this has become enormous over the years but it does create a problem because every time investors borrow yen and sell it to buy another currency that creates additional downward pressure on the yen. So the Bank of Japan is effectively fighting against the system that's developed over decades. Japan spent years keeping interest rates at or around zero and actually at some stages it introduced negative interest rates. It bought enormous quantities of government bonds and encouraged cheap borrowing and now it's trying to unwind that system but you can't necessarily reverse decades of ultra low interest rates overnight and this is where the situation becomes dangerous because Japan has two competing problems. The first is inflation. Japan spent decades desperately trying to create inflation now it finally has inflation and in some areas it has too much of it. Higher oil prices have been particularly painful for the country because Japan imports most of its energy and because oil is generally priced in dollars a weak yen makes that oil even more expensive. So Japan gets hit twice. Global oil prices rise and the yen weakens against the dollar. That means Japan has to pay significantly more in local currency terms for the same barrel of oil. Recent trade figures underlie just how insignificant this has become. Japan's imports jumped by 28% compared with a year earlier. The value of crude oil imports increased dramatically and despite strong exports Japan still recorded a sizable trade deficit. So when the yen weakens this is not simply a financial market story it feeds directly into household bills and fuel costs and electricity and food and transport and manufacturing and basically almost everything that depends on imported raw materials becomes more expensive and that creates political pressure on the Japanese government. But the second problem is almost the opposite. If Japan raises interest rates too quickly that creates major risks for the economy. Japan has an enormous government debt burden. Japanese companies and households have become accustomed to extremely low borrowing costs. The housing market has also become accustomed to very low rates. The government is very happy with financing debt very cheaply and Japanese financial institutions have built business models around that whole environment. So the Bank of Japan is trying to pull off an incredibly difficult balancing act. Raise rates enough to strengthen the yen and control inflation but not so quickly that you create a shock in the bond market or damage the domestic economy. And this is where the USA comes into the story. Japanese investors own huge quantities of US government bonds. For years one reason for that was very simple. Japanese bonds paid virtually nothing. US treasuries offered a much higher return so money flowed out of Japan and into America. But what happens if Japanese bond yields start becoming more attractive? Suddenly Japanese institutions have a reason to keep more money at home. They may decide that they no longer need to take currency risk and buy US debt. And if even a relatively small percentage of Japanese capital starts moving back towards Japan that matters because the United States is currently borrowing enormous amounts of money. US government debt is more than 40 trillion dollars. Treasury yields are already elevated and America needs a constant stream of buyers for its new issue government bonds. So if major Japanese investors become less enthusiastic about US treasuries that could put additional upward pressure on American borrowing costs and that will affect mortgages in the USA and corporate borrowing in the USA and government debt servicing in the USA and equity valuations and potentially the wider US economy. The same applies to Europe. Japanese investors own European bonds and other overseas assets. So higher yields in Japan can effectively compete for capital with Germany, France, the UK and other major economies. And this is why Japan's interest rate decisions matter globally. For decades Japan was effectively a source of very cheap money for the rest of the world. Now that cheap money is becoming more expensive and when the cost of money changes asset prices can change very quickly. We've already seen a glimpse of this with the yen carry trade. When investors suddenly believe the yen might strengthen they start closing out their positions and that means buying back yen and selling other currencies. Potentially selling stocks, bonds and other investments that were financed with the borrowed yen and that can create very sharp market movements. So there are really two risks here. If the yen keeps weakening Japan faces more imported inflation and the possibility of further currency intervention. But if the yen suddenly strengthens dramatically that could trigger a rapid unwinding of carry trades and ironically both outcomes could create volatility in global markets. This is why the level of around 160 yen to the dollar matters so much. Several analysts now think the currency could move back towards that level if the bank of Japan doesn't tighten monetary policy more aggressively. Japanese authorities are already watching the market closely. There have reportedly been rate checks where officials contact banks to ask about current currency market conditions. Historically that can be a sign that intervention is being considered. Japan has already demonstrated this year that it's willing to act. So we're potentially heading towards another confrontation between the Japanese authorities and currency traders. But there is another complication. The United States is also dealing with persistent inflation. Markets are increasingly expecting US interest rates to remain higher or potentially move higher again. And if America keeps raising rates while Japan moves only gradually the interest rate gap stays wide and that supports the dollar and it keeps pressure on the yen. So Japan is not completely in control of this situation. What the Federal Reserve does matters enormously. What happens to oil prices matters. What happens to global inflation is key. What happens in the bond markets is going to be very important. Which is why I think what's happening in Japan right now is much bigger than initially appears. Japan raised interest rates to their highest level in 31 years but the yen weakened. Japan has already intervened in the currency market but the yen remains under pressure. Japan now wants to control inflation but higher rates create their own risks. And Japan wants to stabilize its currency without triggering chaos in the domestic and global financial markets. That is an incredibly difficult position to be in. And if the yen does move back towards 160, the pressure on the Japanese authorities could become intense. Because at that point they effectively have three choices. Raise rates more aggressively. Intervene directly in the currency markets again. Or accept a weaker yen and the additional inflation that comes with it. None of those options are particularly comfortable. And that's why I think Japan is one of the most important economies in the world to watch right now. Because if Japan gets this transition wrong, the consequences are unlikely to stay just in Japan. They could be felt in the US treasury market. In European bonds. In global currencies. In equity markets. And potentially in the cost of borrowing all around the world. So the big question now is not simply whether the yen goes back to 160. The bigger question is whether Japan can finally escape decades of ultra low interest rates without destabilizing the financial system that grew around them. And right now, judging by what the yen is telling us, the market is far from convinced. So I'll keep you posted on any further news and developments. But hopefully you found today's video useful, informative, and most importantly, thought-provoking. Trying to get you to think about the knock-on implications of everything that's happening in the world. Because we're all interconnected. The global economy is exactly that. It's global. It's not just about what's happening in the USA. Lots of other countries have a big impact on what's happening all across the world. So if you liked today's video, then please give me a thumbs up. Please subscribe to the channel if you haven't done so already. And hit that hype symbol if it's available to you. Thank you so much for watching this video through to the end. Thanks to everyone that supported me. If you've bought me a copy, or sent me YouTube super thanks, or signed up as a patron or a member, thank you for that support. That's the thing that keeps me going and making as many videos as possible. And I'll see you again next time.