Perspective #5: The Japan Shockwave

How a 0.1% Interest Rate Hike Shook Global Markets

Dear Curious Investor, 

A foreign country has once again shocked our markets. It’s Japan this time (for a change). 🌏 The same country that we were rumored to surpass in terms of GDP to become the world’s fourth-largest economy for a brief second. Well, Japan continues to be the fourth-largest economy for now and has done something that sent shivers across the world to all markets and economies. 

It just increased interest rates. I am sure you know about it after the 2.68% crash we saw one fine Monday morning in early August 📉 and because it’s been in the news a lot (obviously). Oh, and Divam shared his opinions about the crash last week; join the WhatsApp channel here to find the note. 

So, what’s happening? 

Japan is known to be the epicenter of a lot of earthquakes, and this time, it has triggered an economic quake 🌪️, and tremors are being felt by the entire global economy. The Bank of Japan increased the interest rates in the country for the first time in 17 years, to 0.1%. No, I’m not joking; it really is just 0.1%, but what matters here is the change and not the absolute number. Here’s what interest rates in Japan have looked like for the last couple of decades. 

Yes, you did just see negative interest rates here. What does this mean? This means that in order to put money in your bank account🏦, you need to pay the bank a charge often called the storage charge because:

• The bank is keeping your money safe by storing it, and 

• Banks and the government do not want you to put your money in your bank account, and they are punishing you for doing that.

So, the Japanese government has been asking its citizens not to save and instead splurge away their money 🛍️, but the citizens just are not ready to do that. Thus, BoJ (i.e., Bank of Japan) kept the interest rates very low and even negative to encourage its people to spend more. Has it worked? Nope!

Consumers have been so stringent in their ways that Japan went into deflation. Look at all the years below the 0% line in the chart below. 

Mehengai, in fact, is a very new concept for Japan; it only came into the picture in 2023. (Don't we wish it was us? 🤔). However, Japan “suffered” from deflation for a long time. We often think of high inflation being bad for economies, right, but deflation is even worse! Here’s why: 

Deflation means that consumption in the economy is so low that no one is buying anything unless they have to. No one’s going shopping on their paydays, no one’s celebrating festivals by stocking their homes with groceries and gifts, etc. And economies run on consumption like ours is flying on domestic consumption. ✈️

But Japan, why deflation? 

Simple hai - No demand for goods led to economic pressure and deterioration. Because citizens feared a bad economy, they delayed their consumption further and made no investments to save for the rainy days 🌧️ ahead. This indeed led to poor economic growth. It’s a big loop. 

What was the first trigger, you’d ask? 

• It was the big stock market crash of Black Monday 1987 that tipped this domino of economic degrowth for Japan. And let me mention here that in the 80s, Japan was the world’s second-largest economy, and now it’s tumbled down to fourth. 

• The big asset bubble of the 1980s in Japan—when the prices of real estate and stock assets boomed and boomed until the bubble burst 💥 around the end of that decade. This left the Japanese economy in a struggling state. 

These two events, combined with other factors like BoJ’s actions at the time, and Japan’s heavy imports of staple products like wheat and oil put the economy in a compromising position and it has been bad since. 1991-2001 is even called the lost decade of Japan, where the economy started sliding into recession and degrowth. 

Also, I think it’s fair to say that the one lost decade turned into three lost decades 🕰️. See the GDP growth of the country here and notice the sharp fall in 1998:

So, come the 1990s, the Bank of Japan tried everything to control this situation. It tried expansionary monetary policy and cut interest rates until it couldn’t do that anymore (thus the negative interest rates); it intervened in the global forex market and bought the yen to keep it from depreciating 💱. Reuters has made a really fun interactive blog on this—check it out! 

Oh, and even now, Japan’s economy is running on external demand via exports. So, Japan is reliant on exports to countries like the US, and thus when the US or other major export partners of Japan cry, Japan sobs too 😢.

On NIRP, the Negative Interest Rates Policy: the Bank of Japan took this bold unconventional step of turning its interest rates negative. This is to penalize citizens for putting money in their bank accounts and not spending or investing it. Sadly, this didn’t work either 😓. See here:

BoJ has had a really tough time sprucing up the economy, but what has been done really feels like the move that might just be the thing Japan has been needing. 

Why raise the interest rates now? 

Well, inflation is finally troubling Japan. BoJ wants to maintain inflation of 2% (sounds like a dream, right?). Of late, inflation has been going up in Japan (wait, is it a good thing?), and thus BoJ has finally ramped up the interest rate. It’s causing a frenzy because, on the one hand, consumption has been low in the country, and on the other hand, inflation is now going up. 

There had been talks of BoJ increasing the rates a few months ago too, but the Japanese economy went into degrowth, reporting negative GDP growth for two quarters, and that gave rise to recessionary concerns. And well, rate hikes go well with inflation, but not recession. Here, have a look at the GDP degrowth during the last few quarters 📊. 

But what is all this talk about inflation and interest rates? 

We are primarily interested in the returns on our investments, right? However, the reason behind all this fuss about the interest rates is this only. Economic interest rates affect markets significantly, and that’s why we saw such a huge move in our portfolios the other day. Let me tell you how it is all interconnected.

Understand that we, as investors, have several avenues for putting our money:

- We can spend it on discretionary and non-discretionary products and services,

- We can keep it in our bank accounts (at the rate of interest the bank offers, usually around 4% on savings accounts annually for us Indians), and 

- We can invest that money in various assets—equity or non-equity.

What we choose to do with our money has big implications on the economy and particularly inflation trends. 

When we, as consumers, go to the market and splurge our hearts out, we create demand for goods in the economy. On the back end, producers are making these goods for us. When we demand too many goods with not enough supply, we create a shortage of goods, which leads to the big scary phenomenon called Inflation 🚨.

There are plenty of ways to control inflation, but once it starts to rise, it becomes a very difficult phenomenon to control. Producers do start manufacturing more of the demanded goods, but that takes fresh investment and time for goods to reach the market. 

So, in the end, central banks have to intervene to control the situation. But what does the central bank do? Let me explain with an example of the USA.

Central banks usually have a target inflation for the country, and the Fed has it set at 4%. However, around two years ago, inflation started increasing, and demand for goods was rising consistently. Thus, the Fed needed to gradually decrease demand and bring it to a favorable level. 

To do this, a contractionary monetary policy was adopted, where interest rates were gradually increased by 25 basis points (i.e., 0.25%) for several quarters. What these rate hikes do is encourage people to keep their money in their bank accounts and shop a little less. It also makes loans expensive for both consumers and producers. It also slows down the economy, but more on that later. 

Now when people are getting good interest in their bank accounts and companies can’t borrow to expand their business, investors get discouraged too. Imagine getting good interest from the bank itself that you feel like not investing in other assets, AND putting the money in a bank makes it feasible for you to use it anytime while having a sense of safety for your money 💸.

Thus, investment = discouraged. 

In a nutshell—Increased demand leads to inflation, inflation leads to interest rate hikes, and interest hikes finally lead to decreased investment (and some controlled inflation). 

It’s not over yet; there’s more to it—recession. Decreased demand drives economies into degrowth. The GDP grows slower, and when that happens for two quarters in a row, recessionary concerns arise. This is what happened in the US. The Fed hiked interest rates first to decrease inflation, and then the economy went into recession (and recession asks for rate cuts). Thus, inflation + recession makes it a contradictory situation. 

That was a long lesson on interest rates and inflation, but I hope this gives you some perspective into the hows and whats of interest rates. There’s a lesson on the relationship between interest rates and bond prices too, but I'll leave that for another day 📘.

Now, the contradictory thing I told you about happened in Japan too. As a result of increased inflation, the BoJ had to increase the interest rates finally, and that sent a storm down the house for the whole world 🌪️. And that’s because:

• Japan went from negative interest rates to positive, and 

• BoJ increased rates for the first time in two decades. 

How did markets react?

Nightmarish would be an understatement 😱. Nikkei, Japan’s primary index, has been falling for a month now (ever since rate hike rumors came into the news). This is the largest fall in Nikkei since the 1987 Black Monday crash. Yep, the crash that sort of triggered it all. Look at this very scary image below:

It’s a snippet of the Nikkei 225. It’s not just Japanese indices that reacted like this—the US and China did poorly too. So did other Asian markets 🌍.

The US added fuel to this fire 🔥

The great American economy has been struggling for a long while now. Inflation, recession, political crisis—you name it, and they’d have it. This time, it’s unemployment. July job reports came out of the US earlier in August, and it was not good. Unemployment is rising in America, and that again sent shivers across the world. The world can always rely on the US to make things worse. 🥲🤐

Combine the situation of Japan and US job reports, and you have almost a 3% crash in a day for our NIFTY.

Now happening: Forex Fluctuations 💱

Wages are rising in Japan, and so is inflation. Both these things are very good for the country right now because they signal a growing economy (something that Japan hasn’t been called for a long time). This affects the currency rates too. In fact, something called carry trades is shifting—the currency exchange rate dynamics are changing right now. Very simply put, carry trades are borrowing at low interest rates and investing for higher returns. Until now, investors across the globe would borrow from Japan at low interest rates and invest in other asset classes and currencies like the USD 💵. 

As BoJ hiked the interest rates, these borrowers got scared and started withdrawing money from other assets like the USD, and that triggered a whole chain of currency exchange. Billions of dollars (around $350 billion) were being withdrawn from the US and other countries in a frenzy, fearing the yen’s volatility. And, in this last month, the yen has appreciated significantly. Have a look at this chart to see 📈:

Quick Recap: The yen is appreciating, the Nikkei fell but is now slowly recovering, and Japan is finally moving forward again 🚀.

What’s next now?

Volatility, for sure. I won’t say much for the US because that’s neither predictable nor nice 😅. However, the move from Japan may have a lasting impact for a few more days. I’m not the expert on this—your fund manager Divam is, and here’s what he said. We do feel that the market will present some good opportunities going forward (I’m sorry, but I’m looking forward to correction. I have stocks that have been on UC, and I need a chance to buy them 💸).

I hope this edition helped you understand what’s actually happening in the markets and to your investments. For what you should do now, Divam put some advice on our WhatsApp channel a few days ago, read that!

From the Wise Investor 🤓

"When interest rates change, everything changes." — Warren Buffett

Opinion Corner

With Japan's interest rate hike causing ripples across global markets, are you adjusting your portfolio, or staying the course through the volatility?

That’s all I have for today, see you again soon!

Yours truly,

Isha Bansal