How a butterfly in Japan creates waves in the Canadian economy

Open this photo in gallery:

John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).

It was the kind of news that barely resonates at breakfast tables. Nevertheless, the financial world sat up and took notice. On Tuesday, in the early hours of the morning before Statistics Canada released its latest inflation report, the Bank of Japan officially ended the era of negative interest rates (whereby investors had to literally pay the central bank to hold their money). In so doing, it became the last major central bank to move away from an easy-money policy.

Few Canadians will have taken note of this development, but in time it may affect them in important ways. When the Statscan report revealed inflation to be softer than expected, the yield (or interest rate) on the Canadian government 10-year bond fell by nearly 10 basis points. In response, the exchange rate of the Canadian dollar to its American counterpart lost a penny. It was only when yields in Canada resumed rising as the day went on that the dollar rose back from its lows.

This is called arbitrage, and it’s the key piece in the puzzle of how the Bank of Japan’s decision could ultimately affect Canadians. Arbitrage happens when investors take out loans in one currency, where interest rates are low, then park their money in another currency, where interest rates are higher. For years, Japanese investors have borrowed money for nothing in Japan, then invested it in U.S. bonds, accumulating a stash that is now worth more than $1-trillion.

This added demand for U.S. bonds drove up their value; and since the price of a bond varies inversely to its yield, for years this helped to suppress the U.S. government’s borrowing costs – which creates the conditions for the central bank to set lower interest rates.

Nearly a third of the U.S.’s debt is owed to foreigners, in the form of U.S. Treasury paper, including the bonds the government regularly issues to fund its deficit. Of the foreign holdings, the largest chunk, roughly 4 per cent of the total, is owned by Japanese investors. On a much smaller scale, Japanese investors have similarly traded yen for Canadian dollars, aggressively snapping up Canadian government bonds after 2016, the year the Bank of Japan instituted negative interest rates.

In the short term, this week’s move by the Bank of Japan was so modest that it hardly registered on currency markets. Although the central bank abandoned negative rates, what it now offers is barely above zero, so investors hardly rushed to cash in their foreign holdings and bring the money back home. But as a signpost of what’s to come, this week may prove to be an important turning point.

Given the very expensive transformation under way in the U.S. economy, funded by government subsidies, U.S. borrowing has surged. This means the supply of bonds will continue rising. If the carry-trade from Japan dampens even a little bit, this could cause demand for U.S. bonds to drop to the point their prices start falling. That, in turn, would keep interest rates from coming down. And if U.S. rates remain high, the scope for deep cuts in Canada will be limited by the arbitrage risk of investors dumping Canadian bonds for U.S. ones.

There won’t be a seismic shift any time soon, though. Not least because of what subsequently happened at Wednesday’s meeting of the Federal Reserve. Canada is one of several countries in which inflation continues to decline towards the 2-per-cent target central banks have set for it. Britain released its own inflation report earlier in the day, and it too pointed to a similar softening. But given the outsized impact of the U.S. economy, and the particular dependence of Canada on it, it’s what happens there that matters most.

And what emerged from the Fed meeting was a steady-as-she-goes message. After Jerome Powell told journalists that the Fed was still on track to start cutting rates as early as the summer, and still expected three rate cuts this year, markets resumed rallying, setting new records by day’s end.

Still, the enthusiasts, including property investors in Canada expecting another spring rally like last year’s, may be getting a bit ahead of themselves. Although the Fed is erring on the side of bullishness, the ‘dot-plot’ it released showed that more governors are growing cautious about the current course of inflation. While they still expect rates to come down, they don’t necessarily expect them to come down by much. Future interest rates will likely settle at a higher level than past ones.

That’s because the conditions that kept them low for so long are going into reverse. Put it altogether and despite initial reactions, this week’s events probably hammered yet more nails in the coffin of the cheap-money era, one that has shaped our expectations for decades – including, in Canada, our expectation that house prices will only ever rise.