At the end of last week, the US Federal Reserve sold large quantities of euros to the US Treasury, which subsequently used the proceeds to buy Japanese yen. The Japanese government and the Bank of Japan were purchasing yen at the same time.
At first glance, this extraordinary joint intervention may look like an attempt to rescue Japan’s currency. In reality, the United States is also protecting its own financial interests.
Japanese banks, insurers and pension funds are among the largest foreign holders of US government debt, with hundreds of billions of dollars invested in Treasury bonds. If the yen continued to fall sharply, the Bank of Japan could be forced to raise interest rates much more aggressively – with serious consequences for Washington.
Higher yields at home could encourage Japanese investors to sell US bonds and bring their money back to Japan.
That is a prospect the United States can ill afford. Washington is financing record budget deficits and depends on sustained demand for its debt. Large-scale selling of Treasury bonds would drive up yields, increasing the cost of government borrowing and ultimately leaving US taxpayers with a larger bill.
The Yen Trade Behind Wall Street
Wall Street is also at risk and, from Washington’s perspective, its interests may matter even more than those of American taxpayers. For years, investors have taken advantage of Japan’s extremely low interest rates by borrowing cheaply in yen and using the money to buy US stocks, bonds and other higher-yielding assets. This flow of inexpensive Japanese capital has become an important source of support for American financial markets.
If the yen’s decline forced Tokyo to raise rates sharply, however, this so-called carry trade would begin to unwind. Investors would have to repay increasingly expensive yen loans, potentially prompting large-scale sales of US stocks and other assets. The resulting turmoil could spread rapidly through global financial markets.
Washington’s intervention therefore appears to be less about rescuing Japan’s currency than about shielding US government debt and Wall Street. In defending the yen, the United States is also defending its own financial system.
Originally published on the author's personal website lukaskovanda.cz.