Last Fri­day, Ju­ly 31, some­thing not seen since 1998 hap­pened. Japan and the US in­ter­vened to­geth­er in the for­eign ex­change mar­ket to sup­port the Japan­ese yen. The yen had fall­en to al­most ¥164 to US$1, its weak­est lev­el since 1986. Japan sold for­eign cur­ren­cy and bought yen. The US Trea­sury, act­ing through the Fed­er­al Re­serve Bank of New York, al­so bought yen.

The last US in­ter­ven­tion to sup­port the yen was in 1998. The last co­or­di­nat­ed US and Japan­ese cur­ren­cy op­er­a­tion was in 2011, but that ac­tion pushed the yen down af­ter the earth­quake and tsuna­mi. This time the ob­jec­tive was to cause the yen to ap­pre­ci­ate.

Japan has in­ter­vened on its own re­peat­ed­ly since 2022, with on­ly tem­po­rary suc­cess. Wash­ing­ton join­ing tells traders that a falling yen is now be­ing treat­ed as a wider glob­al fi­nan­cial risk.

The car­ry trade

Since the 1990s the Bank of Japan pro­gres­sive­ly re­duced in­ter­est rates, even­tu­al­ly mov­ing through ze­ro rates, quan­ti­ta­tive eas­ing, neg­a­tive rates and yield curve con­trol. Japan be­came the place where mon­ey was cheap. In­vestors could bor­row yen cheap­ly, con­vert it in­to an­oth­er cur­ren­cy and buy an as­set of­fer­ing a high­er re­turn.

Bor­row at one per cent and in­vest at five per cent and there is a four per­cent­age point spread be­fore fees and cur­ren­cy move­ments. If the yen weak­ens, few­er dol­lars are need­ed to buy the yen re­quired to re­pay the loan.

An or­der­ly ap­pre­ci­a­tion of the yen is part of what the au­thor­i­ties want. A dis­or­der­ly surge is the risk. A six per cent rise can erase more than a year of the in­ter­est rate ad­van­tage. If the po­si­tion is lever­aged and the yen ris­es quick­ly, lenders may de­mand more col­lat­er­al. Traders then sell as­sets and buy yen to re­pay what they bor­rowed, push­ing the yen high­er still. The in­ter­ven­tion seeks to break the one way bet with­out trig­ger­ing a dis­or­der­ly rush for the ex­it.

Car­ry trade mon­ey was not in­vest­ed on­ly in US Trea­sury bonds. Yen-fund­ed cap­i­tal moved in­to US stocks, cor­po­rate bonds, emerg­ing mar­ket debt, com­modi­ties and cur­ren­cies. This car­ry trade is es­ti­mat­ed to be at least US$250 bil­lion and may be sig­nif­i­cant­ly larg­er.

The trade will ex­ist so long as the in­cen­tive re­main. The Bank of Japan has raised rates to around one per cent, but the US Fed­er­al Re­serve re­mains at 3.5 to 3.75 per cent and im­por­tant­ly the ten-year Trea­sury yield is ris­ing, end­ed Ju­ly near 4.75 per cent. The gap is small­er, but still large enough to at­tract bor­rowed mon­ey.

The yen was al­so weak­ened by ris­ing en­er­gy prices, a strong dol­lar and con­cern about Japan’s fis­cal di­rec­tion. A weak yen can help ex­porters, but Japan im­ports much of its fu­el and raw ma­te­ri­als. The same ex­change rate that lifts ex­port prof­its rais­es the cost of elec­tric­i­ty, food, trans­port and pro­duc­tion. Near 164, this be­came an is­sue of house­hold pur­chas­ing pow­er, in­fla­tion and fi­nan­cial sta­bil­i­ty.

Why this mat­ters

Japan is the largest iden­ti­fied for­eign hold­er of US Trea­sury se­cu­ri­ties. Its hold­ings stood at about US$1.14 tril­lion in May. That in­cludes of­fi­cial and pri­vate hold­ings, not one port­fo­lio con­trolled by the Japan­ese gov­ern­ment.

To fund of­fi­cial pur­chas­es of yen, Japan sup­plies for­eign cur­ren­cy from its re­serves, prin­ci­pal­ly dol­lars. It can use dol­lar de­posits, al­low short term se­cu­ri­ties to ma­ture, bor­row against el­i­gi­ble se­cu­ri­ties or sell them out­right. If Trea­suries are sold, all else be­ing equal, prices face down­ward pres­sure and yields face up­ward pres­sure. Japan­ese banks, in­sur­ers and pen­sion funds may al­so re­turn pri­vate cap­i­tal home as Japan­ese bond yields be­come more at­trac­tive.

The ef­fect does not re­quire Japan to dump its US port­fo­lio. Bond prices are set at the mar­gin. With the Unit­ed States is­su­ing large amounts of debt, a small­er Japan­ese buy­er may force oth­er in­vestors to de­mand a high­er yield.

Japan can raise dol­lars against el­i­gi­ble Trea­sury hold­ings through the Fed­er­al Re­serve’s FI­MA Re­po Fa­cil­i­ty rather than sell them out­right. The Amer­i­can in­ter­ven­tion was al­so re­port­ed­ly fund­ed part­ly through eu­ro sales. These mech­a­nisms can re­duce im­me­di­ate pres­sure, but not the longer term ques­tion of whether Japan­ese de­mand for US debt will re­main as strong.

A car­ry-trade un­wind adds an­oth­er com­pli­ca­tion. Traders may sell Trea­suries to raise cash, push­ing yields high­er. Yet if the un­wind be­comes a glob­al pan­ic, oth­er in­vestors may rush in­to Trea­suries as a safe haven, push­ing yields low­er. The im­me­di­ate re­sult is greater volatil­i­ty as com­pet­ing forces bat­tle it out.

That volatil­i­ty reach­es the US mort­gage mar­ket. Amer­i­can mort­gage rates are linked to a spread over longer term Trea­sury rates, par­tic­u­lar­ly the ten year rate. The spread com­pen­sates for pre­pay­ment risk, ser­vic­ing costs and volatil­i­ty.

The av­er­age US 30-year fixed mort­gage rate reached 6.66 per cent at the end of Ju­ly, its high­est in a year. That read­ing pre­ced­ed Fri­day’s in­ter­ven­tion, so it is the start­ing point from which ad­di­tion­al Trea­sury volatil­i­ty could af­fect bor­row­ers, not a con­se­quence al­ready caused by the in­ter­ven­tion.

On a US$400,000 mort­gage, 6.66 per cent rep­re­sents about US$2,571 per month in prin­ci­pal and in­ter­est. An ad­di­tion­al half per­cent­age point would add rough­ly US$134 per month.

That is how a de­ci­sion in Tokyo can reach a fam­i­ly buy­ing a house in Texas or Flori­da. High­er Trea­sury yields and wider mort­gage spreads re­duce af­ford­abil­i­ty, slow hous­ing ac­tiv­i­ty and weak­en house­hold spend­ing.

Emerg­ing ear­kets

Japan and the Unit­ed States bought yen, while traders clos­ing car­ry po­si­tions must al­so buy yen. In the di­rect dol­lar-yen trans­ac­tion, the oth­er side is the sale of dol­lars. In oth­er po­si­tions, traders may have to sell whichev­er as­set or cur­ren­cy they orig­i­nal­ly bought. This does not au­to­mat­i­cal­ly mean a weak dol­lar every­where.

Cur­ren­cies trade in pairs. In an or­der­ly ad­just­ment, the yen can strength­en and the broad dol­lar can soft­en. In a dis­or­der­ly un­wind, the yen may strength­en against the dol­lar while the dol­lar strength­ens against emerg­ing mar­ket cur­ren­cies. In­vestors sell riski­er as­sets, re­pay dol­lar debts and seek dol­lar liq­uid­i­ty. The yen and the dol­lar can both rise, just against dif­fer­ent cur­ren­cies.

That dis­tinc­tion is crit­i­cal for emerg­ing mar­kets. A stronger dol­lar rais­es the lo­cal cur­ren­cy cost of oil, food, ma­chin­ery and dol­lar-de­nom­i­nat­ed debt. It can force cen­tral banks to keep in­ter­est rates high even when their economies are slow­ing. The In­ter­na­tion­al Mon­e­tary Fund has es­ti­mat­ed that, on av­er­age, a ten per cent dol­lar ap­pre­ci­a­tion adds about one per­cent­age point to in­fla­tion out­side the Unit­ed States.

Coun­tries that at­tract­ed yen-fund­ed in­vest­ment face an added prob­lem. When in­vestors sell the lo­cal bond or cur­ren­cy and leave, the cur­ren­cy falls, bond yields rise and im­port­ed in­fla­tion in­creas­es.

T&T ex­pe­ri­ences the ad­just­ment dif­fer­ent­ly be­cause our cur­ren­cy is close­ly man­aged against the US dol­lar. We may avoid the de­pre­ci­a­tion suf­fered by a float­ing cur­ren­cy, but we im­port more of Amer­i­ca’s fi­nan­cial con­di­tions. If lo­cal rates do not ad­just, high US yields widen the re­turn ad­van­tage of Amer­i­can as­sets over T&T as­sets. We have al­ready seen how this in­flu­ences cap­i­tal flows, lo­cal stock mar­ket pric­ing and for­eign ex­change de­mand.

A stronger yen should re­duce Japan’s im­port­ed in­fla­tion by low­er­ing the yen cost of dol­lar priced en­er­gy and food. It may al­so make some Japan­ese ex­ports more ex­pen­sive abroad. If the dol­lar weak­ens broad­ly, the Unit­ed States could im­port some in­fla­tion. If it strength­ens broad­ly, Amer­i­ca re­ceives some pro­tec­tion while pass­ing tighter fi­nan­cial con­di­tions and in­fla­tion pres­sure to oth­er coun­tries.

Un­cer­tain­ty

In­ter­ven­tion can change the speed and di­rec­tion of a mar­ket for a time. It can­not per­ma­nent­ly de­feat the prob­lem un­less the un­der­ly­ing fi­nan­cial con­di­tions change.

For the yen to strength­en on a sus­tained ba­sis, the gap be­tween Japan­ese and Amer­i­can re­turns will prob­a­bly need to nar­row through fur­ther Bank of Japan rate in­creas­es, low­er US rates or both. Low­er en­er­gy prices would help through a dif­fer­ent chan­nel by re­duc­ing Japan’s im­port bill and de­mand for dol­lars. This is an­oth­er way in which the Mid­dle East con­flict in­volv­ing Iran reach­es be­yond the en­er­gy mar­ket. With­out some ad­just­ment, traders will even­tu­al­ly test both gov­ern­ments again.

The im­me­di­ate ef­fect is that the yen car­ry trade is no longer a com­fort­able one way bet. In­vestors now have to price co­or­di­nat­ed in­ter­ven­tion, the pos­si­bil­i­ty of fur­ther Bank of Japan tight­en­ing and a cur­ren­cy loss large enough to over­whelm the in­ter­est earned.

For cap­i­tal mar­kets, that means more volatil­i­ty and less cer­tain­ty that cheap Japan­ese mon­ey will con­tin­ue flow­ing out­ward in the same quan­ti­ties. For the US Trea­sury mar­ket, it cre­ates an­oth­er source of volatil­i­ty and po­ten­tial up­ward pres­sure on long term yields. For the Amer­i­can con­sumer, mort­gage re­lief may be slow­er than ex­pect­ed. That would re­strain hous­ing ac­tiv­i­ty and house­hold spend­ing, with po­ten­tial spillovers in­to glob­al de­mand.

The in­ter­ven­tion took place in the for­eign ex­change mar­ket. Its con­se­quences will not re­main there.

Ian Nar­ine is a fi­nan­cial con­sul­tant who un­der­stands the yen and the yang of glob­al fi­nan­cial flows. Please send your com­ment to ian@ian­nar­ine.com