Japan is fighting the dollar. The dollar is winning

Japan's Ministry of Finance told the Bank of Japan to sell dollars and buy yen on 22 September, its first such intervention since 1998, and officials tried to draw a line near 145.90. The operation was large, using an estimated 2.8 trillion yen of foreign exchange reserves. Within days the dollar was climbing again and heading back towards the line, with little regard for anything officials had said. Japan is fighting the currency market on unequal terms, and the dollar will probably win.

Tokyo does not lack firepower. Japan still holds more than $1.2 trillion in foreign exchange reserves. Its problem lies in the theory. Intervention can work when a currency has drifted away from the fundamentals because of speculative positioning or a passing panic. In 2022 the yen's slide is the fundamentals at work, driven by the wide and persistent gap between the interest rates of a hawkish Federal Reserve and those of a Bank of Japan that will not budge.

Why the carry trade wins

Currency traders live by the carry trade. The Fed has lifted short-term rates past 3 per cent and signalled a peak above 4.5 per cent. The Bank of Japan keeps its short-term rate at minus 0.1 per cent and holds the 10-year Japanese government bond yield at zero. Borrowing in yen to hold dollars therefore earns a wide interest spread with little risk. No treasurer or fund manager can justify funding in expensive dollars when yen are this cheap and plentiful.

The intervention is also sterilised. The ministry buys yen with dollar reserves while the Bank of Japan creates unlimited yen to defend its 0.25 per cent cap on 10-year yields, which amounts to pressing the accelerator and the brake at once. Since April the Bank has offered every business day to buy any quantity of 10-year bonds at that yield, so each investor who doubts the cap can sell to it and receive fresh yen. Yen are soaked up at the front door to prop up the exchange rate, and printed again at the back door to buy government bonds. Taken together, monetary conditions remain very loose.

Why Kuroda will not move

The Bank of Japan has reasons of its own for standing still. Consumer prices excluding fresh food rose by 2.8 per cent in the year to August, above the Bank's 2 per cent target, but Governor Haruhiko Kuroda argues that the rise comes from imported energy and food and will fade, and that without faster wage growth tightening would only choke a weak recovery. The Bank also owns roughly half of all Japanese government bonds, so any retreat from the yield cap would inflict losses on its own balance sheet and raise the government's borrowing costs at once. Its next policy meeting ends on 28 October, and markets expect no change.

A war chest with limits

The contradiction is a gift to global macro traders. Each intervention produces a temporary dip in dollar-yen, which gives investors a cheaper entry into long-dollar carry trades. In effect the Japanese authorities are supplying subsidised liquidity to the people betting against their currency.

Japan's reserves are large but finite. Much of the money sits in US Treasury securities, so sustained intervention would mean selling Treasuries into an already fragile market. That could cause friction with Washington and push US yields higher, which would widen the rate gap between America and Japan and put fresh pressure on the yen.

What turned the yen in 1998

The last episode offers the ministry little comfort. Tokyo and Washington bought yen together in June 1998 with the dollar near 146, and the dollar was higher again by August. The yen's real turn came in October 1998, when the near-collapse of Long-Term Capital Management forced hedge funds to unwind yen-funded carry trades and the currency surged within days. Positioning did the work that official buying could not, and it took a crisis in American markets to set it off.

Joint action is off the table this time. The Plaza Accord of 1985 worked because the five largest economies agreed that the dollar was too strong and acted together to push it down. In September the American Treasury said it understood Japan's decision but did not take part, and with the Fed trying to squeeze inflation out of the American economy, Washington has little interest in a weaker dollar. A lone intervener sells its reserves into a market that the world's largest central bank is pushing the other way.

Who gains from a cheap yen

Exporters such as the carmakers book overseas profits at an ever more generous exchange rate, and foreign tourists will find Japan cheap as the border reopens to independent travellers this month. Households lose, because Japan imports most of its food and nearly all its energy, and dollar-priced fuel has pushed the country into a trade deficit. Japanese life insurers are squeezed another way, since hedging dollar bonds back into yen costs roughly the gap in short-term rates, which leaves currency-hedged Treasuries yielding less than domestic bonds.

The case for Tokyo is that its timing may yet look good. If American inflation turns and the Fed signals a pause, the rate gap stops widening, the line near 145.90 becomes easier to hold and the intervention will be remembered as a well-placed warning. That leaves the outcome in Washington's hands, and the American consumer price report due on 13 October is a better guide to dollar-yen than anything said in Tokyo.

A change at the top in Tokyo could also shift the balance. Mr Kuroda's second five-year term ends in April, and markets are already speculating about whether his successor will loosen the grip on bond yields. Any sign of that would narrow the expected rate gap faster than reserves ever could.

Tokyo's intervention is an expensive way to achieve little. A central bank holding its own bond yields at zero with negative rates cannot also hold up its currency against the dollar, and the yen will keep sliding until one of those policies changes. Until Governor Kuroda gives ground on yield-curve control or the Federal Reserve stops raising rates, the yen will remain the funding leg of choice in global carry trades, and the line near 145.90 is likely to give way before the year is out.