How far will Japan let the yen fall?

The yen has slid towards 151.8 per dollar, its weakest level in thirty-four years. Officials at the Ministry of Finance have turned their verbal warnings up as far as they go, saying they will not rule out 'any steps' against speculative moves. Actually intervening in the currency market, though, poses Tokyo a hard choice.

A rate rise that changed little

The slide has continued despite a genuine shift in Japanese monetary policy. On 19 March the Bank of Japan ended eight years of negative interest rates, lifting its short-term policy rate to a range of zero to 0.1 per cent in its first increase since 2007. It also abandoned yield curve control and stopped buying exchange-traded funds. Markets treated the move as a formality, because the bank said in the same breath that accommodative financial conditions would be maintained for the time being.

That promise matters more to currency traders than the end of negative rates. Across the Pacific, the Federal Reserve has held its policy rate at 5.25 to 5.5 per cent since last July, and investors have spent the year scaling back their bets on how soon it will cut. The gap between short-term rates in the two countries therefore remains above five percentage points. Ten-year Japanese government bonds still yield below 1 per cent, while their American equivalents yield well over 4 per cent.

Why the carry trade keeps paying

The mechanics of the slide are simple. A fund can borrow yen at close to nothing, sell them for dollars and park the proceeds in Treasury bills or bank deposits earning more than five per cent. As long as the yen does not rise faster than that yield gap over the holding period, the trade makes money, and every new position adds to the selling pressure that pushes the yen down further.

Japanese money is moving the same way. Exporters have been slow to bring overseas earnings home, since those earnings are worth more in yen the longer they stay out. Households have been encouraged to invest by the expanded NISA tax-free savings scheme, relaunched in January, and much of that money has gone into foreign equity funds. Energy and food imports, paid for mostly in dollars, keep up a steady demand for the American currency.

A line in the sand invites a test

Defending an explicit level simply gives hedge funds a target to attack. And spending foreign currency reserves to prop up the yen is futile while the Bank of Japan declines to shrink its balance sheet or raise rates by much. Intervention can hurt overstretched speculators for a while. It cannot change the wide gap in interest rates.

The process is well rehearsed. The Ministry of Finance decides, and the Bank of Japan executes as its agent, selling dollars from the government's foreign exchange reserves and buying yen. Those reserves exceed a trillion dollars, so Tokyo can afford several rounds. Each round, however, sells the dollar assets to the very traders who are betting against the yen, and they can rebuild their positions at a better price once the buying stops.

What 2022 and 1998 teach

Tokyo has been here before, and recently. In September 2022 it bought yen for the first time since 1998, and it stepped in again in October of that year as the currency approached the level where it trades today. The yen then recovered strongly over the following months. The intervention deserves only part of the credit, since the rally coincided with signs that American inflation had peaked, a fall in Treasury yields and the Bank of Japan's decision in December 2022 to widen its band for ten-year yields.

The June 1998 episode points the same way. Japan's yen-buying worked then partly because the United States joined in, turning a national operation into a joint signal that the two governments wanted the slide to stop. Washington has shown no appetite for joint action this time, and a unilateral operation carries far less weight with markets. The lesson from both episodes is that intervention works best as a shove in a direction that interest rates are already heading.

Who gains from a cheap yen

The winners are easy to name. Exporters such as carmakers and machinery firms see their overseas profits swell when converted into yen, and foreign tourists find Japan unusually cheap. The stock market has benefited too, since many of the biggest companies in its indices earn a large share of their revenue abroad.

The losers are Japanese households. A weak currency raises the price of imported fuel and food, and real wages have fallen for well over a year as prices outpaced pay. This spring's wage talks produced rises of more than 5 per cent in the unions' first tally, the biggest in over three decades, but those gains can be eroded if the yen keeps pushing import prices higher. That political pressure explains why ministers are talking so loudly.

The case for keeping speculators guessing

There is a fair argument for the Ministry of Finance's approach. By refusing to name a level, officials keep speculators uncertain about when the blow will land, and uncertainty raises the cost of holding large short-yen positions. Officials have also framed their concern around the speed of the move rather than any particular rate, which leaves them free to act on a sharp one-day fall without committing to defend a line indefinitely.

That ambiguity has limits. Warnings repeated for weeks without action become background noise, and the market has already priced in the possibility of intervention without changing course. The approach also depends on events outside Tokyo's control: a run of softer American inflation data would narrow the rate gap far more effectively than any amount of yen-buying.

Signals worth watching

The next American inflation figures, due this week, matter more for the yen than anything said in Tokyo. The Bank of Japan meets again later this month and will publish new growth and inflation forecasts, which will show whether it expects to raise rates further this year. The Federal Reserve's meeting that concludes at the start of May will test whether American rate cuts are receding further. A fast drop in the yen around any of those events is the likeliest trigger for action.

Tokyo's warnings are losing their force. Unless the Bank of Japan tightens properly, any intervention will mostly hand billions of dollars to carry traders, and the yen will resume its slide once the money is spent. If the currency breaks decisively through its 2022 low, the ministry will probably act within days, and the relief will last weeks rather than months unless American rates start to fall.