What’s wrong with the US intervention in the yen and why it risks being an own goal

The extraordinary intervention in the foreign exchange market carried out by the US Treasury on Friday 31 July, in support of the Japanese yen, has raised considerable concerns regarding both the methods used and the reasons behind it. One key concern relates to the absence of any reference to the G7 coordination mechanism, which had previously formed the basis for all interventions in the currency markets. This is the first time that a purely bilateral action has been carried out between the two countries’ Treasury departments. The last intervention involving the yen, which dates back to 1998, was conducted within the framework of the G7. This is a significant development. Interventions in the foreign exchange market affect not only the exchange rates between the currencies directly involved – in this case the dollar and the yen – but also other currencies, starting with the euro. On this occasion, the Americans and the Japanese acted without regard for others, disregarding the system of monetary cooperation established over the last forty years. Journalistic sources report that the European Central Bank was ‘informed’ of the intervention. By contrast, European finance ministers, in particular the President of the Eurogroup, Kyriakos Pierrakakis of Greece, appear to have been kept in the dark. Yet in Europe, monetary policy is a shared competence between the central bank and political authorities. This is all the more surprising given that the purchase of the Japanese currency was carried out not against the dollar, but against the euro – without seeking permission from the Europeans.

The other concern relates to the objectives of the currency intervention. Those stated publicly seem unconvincing. The official justification is that the yen’s exchange rate was too volatile and there was a risk of the currency collapsing. However, the data show that the volatility of the Japanese currency was no greater than that of others. As for the depreciation of the yen, which has been ongoing for months, this is largely due to the spread between US short-term interest rates (just under 4 per cent) and Japanese rates (stuck at 1 per cent). Under these conditions, borrowing in yen and investing in dollars represents a particularly advantageous speculative strategy (carry trade) in the absence of any expectation that the Japanese currency will appreciate.

In fact, the depreciation of the yen is primarily the result of the differing underlying conditions of the two economies. As long as this divergence persists, the yen will continue to depreciate, and foreign exchange interventions will only have temporary effects. To counter the depreciation of the yen, the interest rate differential would need to narrow: the Fed would need to cut US interest rates and the Bank of Japan would need to raise Japanese rates. However, both moves appear unlikely in the current climate. As long as inflation remains high in the US, the Fed is more likely to raise rates than to cut them. In Japan, rates should rise, but the central bank is under pressure from the government to do the opposite. The market seems to have realised this. The joint action initially strengthened the yen by around 8 per cent, but after a few days the Japanese currency gradually began to slip again. Some commentators suspect that the real aim of the intervention is to put pressure on the Fed to prevent it from raising interest rates at its next meeting in September. If it does so, it will undermine the intervention that has just taken place and risks exacerbating the pressure on Japanese equities.

Yields on 10-year bonds have recently reached 2.75 per cent, a level not seen in Japan for the past 30 years. Yields on 30-year bonds have risen as high as 3.90 per cent. The US Treasury fears that a crisis in Japanese debt – which has stabilised at around 205 per cent of GDP – could affect the US government bond market. The intervention was carried out in euros rather than dollars precisely to avoid encouraging the sale of US government bonds, which would have had a negative impact on investor confidence. The interesting – and largely overlooked – aspect concerns the effects of the intervention on the euro-dollar exchange rate. One might have expected that selling euros would have weakened the European currency. Instead, the euro held its ground and even strengthened against the dollar. This suggests that the financial markets now consider the euro sufficiently robust and liquid to absorb this type of intervention. It also suggests that the financial markets are not entirely convinced of the validity of the intervention carried out by the US Treasury or of its consistency with monetary policy. The US intervention on the yen is not yet an own goal, but it risks becoming one soon.