What happens to a currency when its central bank raises interest rates? If you answered that it should strengthen, you are in good company, and last week you were wrong.
On 18 September, the Bank of Japan raised its policy rate by a quarter of a point to 1.25 per cent, the highest level since 1995. Within hours, the yen had weakened, with the dollar climbing back above 157 yen. A rate rise followed by a weaker currency would normally look like a textbook mistake. It is actually one of the most useful lessons in how markets think.
What the Bank Did
The decision was a seven-to-two vote, with two board members preferring to hold rates where they were. Governor Kazuo Ueda declined to commit to any particular pace for future increases, effectively leaving the board to keep its options open. The next meeting, on 29 and 30 October, comes with an updated economic outlook, and traders are already treating that as the real event.
It helps to remember how unusual this is for Japan. For most of the last three decades, Japanese rates sat at or below zero. A policy rate of 1.25 per cent would look modest almost anywhere else. In Tokyo, it is a generational shift.
Why the Yen Fell Anyway
Three things were going on at once.
Firstly, the rise was expected. Traders had already bought the yen in anticipation, and when the news arrived, there was nobody left to buy. Markets have an old phrase for this: buy the rumour and sell the fact, and it applies far more often than it should.
The second is the messaging rather than the move. A divided board and a governor unwilling to commit to further increases suggest that Japanese rates will rise slowly. Currency traders care much more about where rates are heading than where they are today, so a cautious signal took the shine off the hike itself.
The third is the gap. Two days earlier, the Federal Reserve had raised American rates to between 3.75 and 4 per cent. Even after Japan’s increase, the difference between what you earn holding dollars and what you earn holding yen remains enormous. As long as that gap persists, borrowing cheaply in yen to invest elsewhere stays attractive, and that steady selling of yen keeps weighing on it.
Why a British Reader Should Care
You might reasonably think the yen is far from your life. It is closer than it looks.
Japanese investors are among the largest holders of foreign bonds worldwide, including British government debt. As their home rates rise, the incentive to bring that money home grows, and a slow withdrawal of Japanese capital would nudge up borrowing costs in the countries they leave. Japan is also a large slice of most global equity funds, which means a portfolio built on a world tracker already has more exposure to the yen than most people realise.
I have written about how the dollar’s gravity shapes money moves around the world, in Stripe, PayPal and the Quiet Dollar Race. Last week is a reminder that gravity is not only about payments. It is about interest rates too, and the dollar still has the stronger pull.
The Lesson I Keep Relearning
I am naturally impatient, and my instinct with news like this is to react to the headline. Interest rates are up, currency up, done. The market spent last week explaining, rather politely, that the headline was the least important part.
Currencies, like shares, trade on expectations. The question is never simply what happened. It is what happened compared with what everyone already assumed, and what it suggests about what is next. CNBC’s coverage of the decision is a good place to see how quickly the reaction turned. The rate went up. The expectations went down. The yen followed the expectations.
The Jacqueline Brand — knowledge builds confidence, confidence builds wealth. This is editorial commentary for inspiration, not financial or professional advice. Always do your own research. The Collection
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