In addition to trade balances and economic growth differentials, there are two other macroeconomic forces -- the relative size of fiscal deficits and the relative state of monetary policy -- that impact currency valuations.  Larger trade or budget deficits, easier monetary policy and slower growth tend to pull currencies lower whereas smaller trade and budget deficits, tighter monetary policy and faster economic growth tend to push them higher.  JPYUSD has been no exception to these rules.

Except for a brief period in 2014, Japan has consistently run trade surpluses while the U.S. has run constant trade deficits over the past several decades (Figures 2).

From 1996 to 2007, Japan’s current account surplus rose at the same time as the U.S. current account deficit increased.  The yen didn’t show a strong reaction to this development, perhaps for reasons related to monetary policy: Japanese interest rates were stuck near zero while U.S. rates ranged from 1% to 5.25%.

Where the influence of the trade balance on JPYUSD became most apparent was in the period after the global financial crisis.  With both U.S. and Japanese rates stuck near zero, relative changes in the trade balance exerted a clearer influence on the currencies.  From 2011 to 2014, Japan swung from a trade surplus to a trade deficit and, with a lag of about 12 months, JPY weakened by about 38% versus USD (Figure 3).

Since 2014 a weaker currency has worked its magic, making Japanese exports more competitive, while simultaneously making it more expensive for the Japanese to buy imported goods.  With Japan moving back towards trade surpluses and the U.S. continuing to run current account deficits, JPYUSD has been relatively stable since.

At the beginning of the global financial crisis in 2008, the U.S. trade deficit shrank rapidly as did Japan’s trade surplus.  Taken in isolation, one might have expected this to weaken the yen versus the dollar but instead the yen strengthened, likely due to the impact of U.S. monetary policy overwhelming the impact of trade. 

Going into the global financial crisis, Fed funds were at 5.25% compared to 0.5% in Japan.  As such, when the crisis began, the Fed cut rates by 500 basis points (bps) while the BoJ could only cut by one tenth as much.  This sent JPY soaring (Figure 4).

From 2009 to 2015, with both the Federal Reserve (Fed) and the BoJ stuck at zero, trade took over as the currency pair’s primary driver.  However, from 2016-18 the Fed tightened policy as the BoJ kept rates low.  This likely prevented JPY from strengthening versus USD even as Japan’s trade surpluses expanded.

Interest rate differentials are only one aspect of monetary policy. Quantitative easing is another.  The BoJ dabbled in QE during the 2000s but did not fully embrace the idea until the Fed and the European Central Bank (ECB) brought it into the mainstream in 2009.  From 2009 to 2012 quantitative easing by the BoJ was roughly in line with that of its peers (Figure 5).  Beginning in 2013, however, the BoJ embarked on a QE program that remains without precedent in terms of its size and scope, eventually expanding its balance sheet to over 130% of GDP, roughly twice what the ECB did and over three times as much as the Fed.  The BoJ also went deeper down in terms of credit quality, going so far as to buy equity index ETFs.

The impact of Japan’s QE program on the yen is not entirely clear.  JPY weakened in 2013-14 as the BoJ ramped up its QE program at the same time as the Fed was winding down its use of quantitative easing.  From 2015 to 2018, the BoJ continued its QE program as the Fed began shrinking its balance sheet (Figure 6).  But QE has often seemed like more of a lagging indicator of JPYUSD than a leading one.

In addition to doing QE, the BoJ also did something that the Fed has thus far avoided.  On January 29, 2016, the BoJ followed the ECB and the Swiss National Bank (SNB) in setting negative deposit rates.  The idea behind negative interest rates was simple: making investors pay to deposit money would discourage holding deposits, weaken currencies and encourage investment in risky assets, boosting output.  Instead, the opposite seems to have occurred to all three currencies.  Currencies strengthened without any obvious economic gains.  Just as EUR and CHF had done, JPY strengthened after the BoJ set deposit rates negative at the end of January 2016 (Figure 7).

One thing is clear, however. Despite QE and negative rates, Japan is still experiencing deflation even as inflation surges in the U.S. and elsewhere.   In the U.S., the Fed is already talking about ending QE and rate hikes are priced into forward curves for 2022 and 2023.  The same is not true in Japan.

It may be the case that negative interest rates tax the banking system, and deter rather than spur lending.  Growth rates in Europe and Japan have lagged those of the U.S. in recent years despite (or perhaps because of) negative rates (Figure 8).

It was not always thus. Between the end of the Bretton Woods fixed exchange rate system in 1971 and 1994, the yen soared 340% against the dollar.  During the 1970s and 1980s, Japanese economic growth was generally much faster than that of the U.S. and it was during this period that Japan began running current account surpluses as the U.S. sank into larger and larger trade deficits.

The popping of the real estate bubble in the early 1990s altered the picture.  Japanese economic growth slowed to levels far below those of the U.S. To offset slowing growth, Japan began to run large budget deficits of 3-6% of GDP during periods of expansion, and deficits of 8-10% during periods of economic contraction.  Public debt levels swelled from 60% of GDP in 1989 to over 200% of GDP by the late 2010s. The persistence of large budget deficits and slow economic growth have most likely counteracted the effect of Japan’s persistent trade surpluses and prevented the currency from strengthening.