Japan’s economy has been dealing with a weak currency for the past 10 years. It came to a head in the last week of July, with the Ministry of Finance intervening in the currency market along with the U.S. Treasury as they tried to avoid what could have been further disorderly depreciation of the yen.
The intervention succeeded in pushing the yen from its bottom at 163 versus the U.S. dollar to 157 on Aug. 3.
In the two weeks since, trading has taken back some of that appreciation with the yen once more landing at 159 as of Friday and looking to weaken further without the assurance of changes in Japan’s monetary and fiscal policies.
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We expect currency speculators to test 160 in the runup to the Bank of Japan’s policy meeting on Sept. 17-18, where investors now anticipate an 80% probability of a rate hike out of the central bank.
In addition, investors expect an additional three hikes by July next year which would alter the dynamics of the globally important carry trade that indirectly influences American interest rates.
We have made the case that the near-term success or failure of the coordinated U.S.-Japan intervention into currency markets would be defined by a change in policy at the Bank of Japan.
But it is far more likely that global financial markets will have the last say on whether the intervention was successful.
From our vantage point, structural debt and deficit dynamics inside Japan will drive risk appetite inside that economy and shape investors’ expectations of Tokyo’s ability to sustain its challenging fiscal situation.
Unless the Bank of Japan hikes its policy rate and the government spurs stronger growth through expansionary fiscal policy, one should anticipate that investors will challenge the willingness of Tokyo and Washington to sustain that initial intervention and again push the yen toward 170.
State of play
In 2016, it cost Japanese investors 100 yen to purchase one unit of a U.S. Treasury bond or one unit of a dollar-denominated barrel of oil. This year, it costs roughly 113% more to purchase each dollar needed for an international transaction.
While the cheapness of the yen might have made Japan’s exports more attractive, Japan’s economy continued to sink under the weight of its zero-interest rate monetary policy.
This latest episode of intervention, while laudatory for helping a trusted ally, serves to restate the folly of thinking that anything other than market demand can dictate what a currency’s value should be.
Was it necessary to join Japan’s intervention?
By all indications, the U.S. Treasury joined the intervention to keep a lid on U.S. interest rates as it attempts to finance the fiscal spending of the legislature and the executive branches of government by avoiding an increase in interest rates that would have followed a Japanese-led intervention.
All indications were that Japan’s Ministry of Finance was selling its holdings of Treasury securities to finance its intervention.
From February to May, the latest data available, Japan’s holdings of Treasury securities fell from $1.239 trillion to $1.143 trillion, an 8% drop. Holdings in the Netherlands dropped by 17%.
Selling Japan’s Treasury holdings would of course have the effect of lowering the demand for dollar-denominated securities, pushing down price and increasing the yield required by investors in the midst of a bond-market selloff.
The front-end of the yield curve was steepening on perceptions of eventual rate hikes by the Federal Reserve contending with sustained inflation, with 2-year notes testing 4.17%. The 10-year was testing 4.7%, and the 30-year at 5.25% was the highest since 2002.
The Treasury’s part in the intervention was not to sell the dollar and buy the yen, but to sell euros in order to buy the yen.
Selling euros looks like an attempt to wish away the problem to another ally.
While Japan is the largest single holder of U.S. Treasuries, the combined official holdings of the European Union members is in fact the largest holder, with the euro the predominant currency in the EU.
Much of Europe’s international transactions take place in financial centers in the Netherlands, Belgium and London. We note the sharp drop in holdings since February in both Japan and the Netherlands as an assessment of the policy choices in both the U.S. and Japan.
As for the Treasury Department’s strategy of financing U.S. debt with short-term, lower-yielding Treasury bills, foreign holdings of bills and bonds have both moved lower in recent months, with the reduced demand for both short-term and long-term securities pushing yields higher.
The takeaway
History has proved that the market always has the last say.
Intervention in the foreign exchange market by Japan and the U.S. was in the interest of both governments as they hoped to stem the further devaluation of the yen and the U.S. bond market selloff.
Whether this effort turns out to be successful is up for grabs.
The yen is backtracking in recent trading, but traders will be more cautious as it approaches 160 again, perhaps putting a floor under its deterioration.
U.S. interest rates are likely to continue moving higher if inflation remains above the Fed’s target and if the market deems U.S. debt at more than 120% of gross domestic product as unsustainable.
