Brad Setser on the US's Unusual Japanese Yen Intervention

Brad Setser argues the Bank of Japan has been very slow to raise rates despite inflation running well above the current 1 percent policy rate, compared to the Fed's rate of between 3.25 and 3.5 percent. He attributes BOJ hesitation to reluctance to prematurely end the shift away from a zero-rate zero-inflation economy and possible concern about pushing up funding costs on banks holding many low-yielding assets. Setser considers the argument that the BOJ is holding back to protect the government's fiscal position overstated, though he acknowledges it as one factor.

Yen weakness reflects interest rate differentials rather than fiscal fears. Shorting the yen is positive carry because dollar yields exceed yen yields, and hedge funds bet the yen would weaken to 170 on the view that BOJ governor Ueda was behind the curve. Much of the actual yen weakness reflects hedging flows among real money investors rather than classic speculative positioning, and the yen has decoupled from five-year and ten-year rate differentials for roughly the past year. At 160 yen per dollar, the yen is below its inflation-adjusted 1970s level in real terms, which Setser describes as extreme undervaluation.

The US and Japan intervened jointly, with the US selling euros rather than dollars, allowing Treasury Secretary Bessent to frame the action as a view on the yen rather than a view against the dollar. The euro-yen rate check caused confusion in the market. The vast bulk of the intervention was conducted by Japan's Ministry of Finance in dollar-yen, making it fundamentally a dollar-yen intervention, and the exact volume of US participation is unknown. Bessent's to-do list referenced buying Japanese yen in an amount of five to ten billion dollars. Bessent framed yen weakness as destabilizing the broader Asian currency complex rather than citing the traditional concern that yen weakness gives East Asian exporters a trade edge over American manufacturers. Setser sees this framing as significant given that the global trade surplus is now concentrated in East Asia, with Korea's current account surplus expected to rise from roughly 100 billion dollars to between 300 and 400 billion, and Taiwan's current account surplus expected to roughly double from around 15 percent to 25 to 30 percent of GDP.

The FIMA repo facility allows foreign central banks to use Treasury holdings as collateral to obtain dollars without selling bonds into the cash market. It carries a premium above market rates and is capped at approximately 60 billion dollars. Japan has historically sold Treasuries directly rather than using its cash buffer when intervening, so use of FIMA repo represents a departure. A Ministry of Finance holding a legacy five-year bond with a high coupon can cover the FIMA repo premium from the coupon and avoids locking in a sale at a lower yield. Setser notes disclosures occur with a lag, making the Fed a quieter counterparty, and the facility carries zero risk to the Fed because any monetary impact can be offset with domestic operations.

Japan holds close to 1.2 trillion dollars in foreign exchange reserves, the government pension fund holds over 900 billion dollars in foreign assets, and Japan's GDP is approximately 4 trillion dollars, putting the government's foreign asset position close to 50 percent of GDP. Setser argues that if Japan changed pension fund operating guidance to hedge its roughly 950 billion dollar portfolio, there would be collective firepower to set a yield curve control type target around 150 to 160 yen. The current intervention is fundamentally about reestablishing fear around the 160 level to deter short-yen positions. Setser predicts the intervention will be tested and likely insufficient if the BOJ does not raise rates in September, but sufficient if the BOJ raises rates, potentially multiple times. Long-term Japanese rates have converged with long-term US rates, meaning the long-run interest rate differential is now at odds with yen weakness and implies the yen should be stronger.

Setser rejects fiscal fears as a driver of yen weakness and argues Japan's fiscal position is stronger than commonly understood. Japan's primary fiscal balance excluding interest is now flat, making it one of the better G7 economies and better than the US, UK, France, and likely Germany. Japan's fiscal deficit was approximately 1 percent of GDP last year versus the US at roughly 5 to 6 percent. Japan's net debt levels have been falling over five years while US net debt will surpass or approach Japan's net debt level. Setser notes that shorting the yen and going long the dollar means going long US fiscal, which compares unfavorably to Japan when examining net debt dynamics and primary balance trends. Japan bought dollars at between 80 and 100 yen and is now selling them at around 160 yen, and Setser argues this intervention operation reduces Japan's gross debt in a meaningful way.