A line in the sand for the world’s largest creditor has been breached
Last week, the Japanese yen fell to a 40-year low against the US dollar, crossing what the Bank of Japan considers to be a “line in the sand”. The weakness of the yen has negative effects on the economies and financial markets of the rest of the world, especially America.
The yen fell to 162 yen against the US dollar (the BOJ’s red line) and fell to 162.51, before rising again later in the week to just over 161 yen against the dollar as US payrolls data suggested the prospect of an imminent rise in US interest rates may have weakened.
There is a strong correlation between the US economy and its interest rates and currency, as well as Japan’s. The interest rate differential (the relationship between US and Japanese bond yields) drives the relationship between currencies.
For decades, as the BOJ’s policy rate was negative during Japan’s post-1980 economic recession, capital flowed out of Japan in search of higher returns elsewhere, particularly in the United States. The Japanese government, insurers, pension funds and individuals collectively own more than US$1.2 trillion ($1.73 trillion) in US government bonds.
It is interest rate differentials, particularly the difference between U.S. and Japanese rates, that have created the decades-old “carry trade,” in which foreign investors borrow cheaply to invest in high-yielding assets (government bonds, stocks, property and other assets) elsewhere.
Japan has effectively become a source of ultra-low-cost financing for the rest of the world.
This situation began to change two years ago when the BoJ increased its policy rate from below zero to 0.1 percent. Then, with its latest move, it increased this rate even further, from 0.75 percent to 1 percent last month.
Despite the increase in this rate and the significant movement in market rates (the 10-year bond yield jumped from 2.06 percent at the beginning of this year to 2.78 percent and the 30-year bond yield jumped from 4.85 percent to 4.99 percent), the gap with U.S. interest rates and the opportunity to carry trading profits remained wide, although narrowing.
Moreover, as US inflation continued to rise for most of this year (the Federal Reserve Board’s preferred core personal consumption expenditure rate increased by 30 basis points to 3.4 percent in May, well above the Fed’s 2 percent target), the expectation in financial markets was that the deficit would widen.
Japan’s inflation rate, which had been non-existent during the decades-long economic winter, has also risen and is heading towards 2 percent.
But its relatively new prime minister, Sanae Takaichi, has made clear that he wants the BOJ to move slowly in tightening and normalizing monetary policy, even as he embarked on an expansionary fiscal policy earlier this year, including a $190 billion stimulus package and ambitious plans to invest ¥370 trillion in artificial intelligence, semiconductors and other high-tech sectors between now and 2040.
The cautious combination of tightening monetary policy while the fiscal taps are turned wide would normally be disciplined by the bond market, but with more than half of the bonds in the Japanese market held by the government (along with significant exchange-traded funds and real estate investment trusts that have been building up over fifteen years), this is not a normal market.
It is the exchange rate that reflects the possibility that the gap between US interest rates and Japanese interest rates may widen (unless the new Fed chairman, Kevin Warsh, can somehow convince his Fed colleagues to ignore the rise in US inflation and carry out the interest rate cuts that Donald Trump is demanding).
The BOJ intervened in foreign exchange markets to stem the yen’s depreciation, spending the equivalent of more than $100 billion to push the currency up.
There is a history of intervention – in the past it was usually to prevent the yen from appreciating – but the effect of these events has generally been to soften rather than halt changes in the direction of relative value.
This is because as long as interest rate differentials with the rest of the world persist, incentives to borrow cheaply to invest elsewhere remain in Japan. This is a structural problem.
Markets are alert to new interventions. In order to defend the yen, the BoJ sells some of its foreign exchange reserves in order to buy the yen. There are concerns that if it is forced to support the yen for an extended period, it will be forced to sell some of its largest offshore assets, which are dominated by US bonds.
As the largest foreign investor in the U.S. Treasury bond market and America’s largest foreign creditor, large-scale sales of dollar-denominated assets would hit that market, driving up yields and increasing the U.S. government’s already rising borrowing costs.
With the U.S. government inauguration on track to reach $40 trillion in debt in the next few months and the second Trump administration being as wasteful as the first (adding more than $3 trillion in debt in less than 18 months after the first Trump presidency added $7.8 trillion), rising yields and declining liquidity in the bond market will increase government borrowing costs and could put pressure on liquidity in the U.S. financial system.
Indeed, a large-scale withdrawal by Japan from overseas markets would have global implications for bond markets, which were already made more vulnerable by the massive amounts of government debt issued globally by central banks in response to the 2008 financial crisis and subsequent pandemic. Before the pandemic, global government debt was under $90 trillion. It could approach $120 trillion this year.
The last thing the United States or the world needs is for its largest creditors to reduce the flow of funds.
Takaichi doesn’t mind a weak currency because it makes Japan’s exporters more competitive in overseas markets and boosts efforts to create industry-led growth. This also increased tourism significantly.
But Japan imports most of its oil and natural gas and is not self-sufficient in food; Therefore, the depreciation of the yen increases inflation and puts household finances under pressure. With a debt-to-GDP ratio of over 200 percent, there is a limit to how long and for how long its government can continue to compensate Japanese consumers for inflation.
Trump’s war on Iran has not helped Japan, given the impact of high energy prices and a depreciating currency on the country’s energy costs.
For investors, the consequence is the tension between Takaichi’s desire to use expansionary fiscal policies to normalize and grow Japan’s economy and complete the task undertaken by his mentor Shinzo Abe, and the Bank of Japan’s desire to tighten monetary policy to control the inflation rate and maintain currency stability.
Japan’s austerity and unconventional monetary policies have helped lower borrowing costs for the rest of the world for much of the last three decades. Any structural change in the relationship between its own bonds and currencies and the bonds and currencies of the rest of the world would be significant – especially for the US – and not in a good way.
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