STEM major here. I saw this recently about how Japan raised its interest rates to .25%. Can someone please explain to me how this strengthens the yen? In addition to this why would the US increasing interest rates at this time decrease the value of the dollar? Please help me I’m lost here 😅 have a great day everyone!
In: Economics
This is a really weird case. Because Japan had really low (even negative) interest rates, a lot of people put up foreign currency as collateral to borrow way more Yen for free (or even to get paid to do it). They then sold those Yen, dropping the value of them, to purchase foreign currency such as Dollars and invest them, further enhancing their gains.
When the interest rates rose above zero, the people who held those loans suddenly owed some money, and had to sell their Dollar-denominated securities and buy Yen. That raised the price of Yen. Now, the collateral they put up is not enough to cover the loan, so…they need to sell more Dollar-denominated securities and buy *more* Yen.
Wash, rinse, repeat.
Currencies are all about supply and demands. If people desire to possess a currency for whatever reason, it will appreciate and if everyone dumps it, it will depreciate.
A country typically issues bonds in their own denomination (e.g. you need to have yen to purchase Japan bonds, and USD to purchase US bonds). When Japan increased their interest rate, people purchased yen (to buy Japan bonds) and make it appreciate.
0.25% doesn’t seem much but historically, everyone has been dumping the yen the moment they got it (because Japan bond paid 0% interest) and people even borrow in Japan to invest somewhere else (because again, interest in Japan was low) so when it suddenly started paying interest, these people now has borrowing cost and needs to massively downsize their operation.
All else being equal, a central bank increasing the interest rate makes a currency more attractive because relatively safe investments denominated in that currency (e.g. government bonds) now generate more returns (because the interest paid on those bonds have gone up), which means increased demand for the currency from investors looking to invest in those assets, which means the currency grows stronger.
Where have you seen the dollar suffer after increasing rates? The US dollar has appreciated considerable post covid precisely because the fed jacked up interest rates to combat domestic inflation.
Money is mostly created when customer facing banks borrow from central banks. The higher the interest rate the central bank charges, the less demand from the customer banks, so less money is created. Less of something means it is more valuable, so the currency becomes stronger.
The interplay among different currencies is more complex, but very simply the major currencies sort of compete to be the standard by which others are measured. If one currency gains in strength the others may drop even in relation to a third currency. Basically there is a market of people who want to park money in the “safest” currency, when a currency becomes more valuable more of that market will think it’s the safest.
(Before anyone goes all “ackshually” on the above, I know it isn’t 100% accurate. It’s a drastic simplification of a complex phenomenon for ELI5.)
Another reason why the Nikkei dropped like crazy is Japan has a significant amount of stocks held by foreign traders. Since the US dollar dropped like crazy, many just sold stocks to pay off their debt.
I will try to summarize the key points as concisely as possible.
1. Japan’s interest rate has historically been low, and the Yen has remained weak.
2. Considering this, investors often obtain loans in Yen at low-interest rates to invest in other countries with higher returns. For example, they might secure a loan in Japan at a 1.5% interest rate and invest in U.S. Treasury securities to earn a 4.5% return. This strategy is known as the “carry trade.”
3. However, when the Bank of Japan raises interest rates, as has been occurring recently, the carry trade becomes riskier. Investors may sell their foreign assets to buy more Yen to repay their loans in Japan.
4. When a large number of investors sell their foreign assets, the demand for Yen increases, leading to an appreciation in its value. The issue arises because Japan’s economy is heavily reliant on exports, and an appreciating Yen reduces the profitability of Japanese businesses.
5. Consequently, Japan’s market is experiencing a downturn. As future profit expectations for Japanese businesses decline, market valuations are adjusted downward, reflecting reduced anticipated profitability.
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