The coordinated intervention by Japan and the U.S. to prop up the yen took place in the currency markets, but the actions mainly resulted from pressures from global bond markets.
The weakening of the Japanese currency to its lowest levels in four decades reflects markets' concerns about Japan's fiscal path, with the highest ratio of debt to gross domestic product in the developed world, and the Bank of Japan's slow, grudging rise in its policy interest rate to just 1%, despite inflation exceeding its 2% target for the past four years.
As Japan's long-term bond yields have moved to record levels -- with 30-year maturities nearing 4% after having hovered around 0% for nearly a generation -- long-term government bonds across global markets have sold off.
Each market has a local explanation, writes Michael Green, chief strategist and portfolio manager for Simplify Asset Management, on Substack. In the U.S., there are deficit concerns, massive spending on artificial intelligence, and disquiet over new Federal Reserve Chairman Kevin Warsh's reticence about offering forward guidance. In the United Kingdom, it's fiscal credibility; in Germany, it's the cost of rearmament; and in France, it's politics.
But what they share is more important: They are funded from the same global pool of long-term capital, says Green. Prominent among them have been Japanese financial institutions, such as life insurers, who have been forced to move money overseas to generate returns to meet the cost of their liabilities. That trend reflected Japanese policies of holding short- and long-term interest rates near zero to stir the nation's economy out of its multidecade torpor.
But artificially capping Japanese interest rates effectively shifted the fiscal stress to the currency market, notes Robin Brooks, a senior fellow at the Brookings Institution and former chief foreign-exchange strategist at Goldman Sachs. The yen is falling because Japan's high public debt -- over 230% of GDP -- prevents the country from allowing yields to rise freely, he writes in his Substack post. If the BOJ were to stop buying bonds, the yield would be at least 300 basis points (three percentage points) higher, putting Japan into a fiscal crisis.
Even with repression of Japanese government bond yields, Green posits they have risen enough for Japan's insurance companies to buy domestic bonds to satisfy their liability targets. After the cost of hedging exchange-rate risks, the 4% on 30-year JGBs compares favorably with 5.2% on 30-year U.S. Treasuries for a Japanese investor.
This removes a major buyer on which the developed world's long-term borrowers have depended upon -- and effectively provide an invisible subsidy to deficit-running major governments, Green continues. But that is ending as the BOJ normalizes interest rates and draws Japanese institutions back home. This doesn't mean Japanese investors are selling Treasuries outright, but that they are becoming less willing to act as marginal buyers, which set prices.
The mechanics of the latest currency intervention further attest to sensitivity about the impact on U.S. bond yields. Shoring up the yen against the dollar would typically mean selling U.S. assets -- mostly Treasury securities -- for the Japanese currency, which would tend to push up U.S. yields. Instead, the U.S. sold euros for yen while Japan borrowed from the U.S. Foreign and International Monetary Authorities facility to limit selling of Treasuries.
As PNC economist Isfar Munir explained in a client note, official sales by the Ministry of Finance and Japanese private sector rotating out of U.S. Treasuries into yen assets puts pressure on the U.S. debt market. That is something the Treasury wants to avoid, given the U.S. fiscal deficit running at 6% of GDP, a level previously seen only in declared wars or recessions.
At the same time, the Treasury continued its program to limit note and bond issuance while leaning on short-term T-bills to fund the deficit. In announcing its quarterly financing plans this past week, the Treasury left open the possibility of cutting back those coupon-bearing securities in the future, leaving it even more dependent on T-bills. Most government securities dealers look for bigger note and bond sales next year.
While the Fed keeps its federal-funds target range at 3.50% to 3.75%, T-bills (which track the funds rate) cost the Treasury less than notes and bonds as it prepares to auction $125 billion in fresh three-, 10-, and 30-year securities this coming week. Outstanding issues of those maturities on Thursday traded 4.31%, 4.67%, and 5.22%, respectively. Moreover, by limiting issuance of longer-term securities, the Treasury is effectively promoting easier financial conditions, offsetting expectations of future Fed rate hikes, writes Erik Norland, chief economist of the CME Group.
The irony is that, to reverse an observation from Treasury Secretary John Connally under Richard Nixon, it's Japan's yen but it's also our problem. Japan has artificially held down its interest rates, until recently to zero or less, for decades, which in turn lowered borrowing costs for the rest of the world. The result of this monetary excess predictably has been a weak yen and persistent inflation, especially for imports, notably oil, which remains 50% higher (in dollar terms) than at the beginning of the year.
A reversal of capital outflows from Japan as interest rates there rise comes at a time when bond markets in the rest of the world need buyers. As noted, fiscal pressures are being felt in the U.K. and continental Europe. At the same time, the U.S. fiscal deficit shows no sign of abating, along with massive corporate funding for AI projects (highlighted by another massive $25 billion debt deal this past week from Alphabet).
The visible signs of stress appear in currency markets but emanate from debt markets.
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