Japan steps in to save the yen

Japan's Ministry of Finance intervened in the currency market again on 11 July, moving straight after softer-than-expected US consumer price figures came out. With the dollar already weakening, it spent billions from its reserves and pushed the yen from a thirty-eight-year low of 161.9 back toward 157 per dollar.

This is the third bout of yen-buying in little more than two years. Tokyo first stepped in during September and October 2022, its first purchases of its own currency since 1998, and returned at the end of April and start of May this year, when the yen briefly weakened past 160. Each time the currency recovered for a few weeks and then resumed its slide.

Timing the squeeze

Stepping in just after a data surprise maximised the losses for leveraged traders betting against the yen. But well-timed intervention does not fix the underlying problem. As long as the Bank of Japan keeps rates near zero while yields elsewhere are much higher, Tokyo is only renting short-term relief, and paying heavily in reserves for it.

The tactic was clever. Soft American inflation figures had already sent US yields lower, so traders were caught between a data shock and an official seller of dollars at the same moment. Intervention that leans in the same direction as the news gets more movement per yen spent than intervention that fights it. Tokyo also declined to confirm the operation straight away, leaving speculators to guess at its size and whether more was coming.

The size of the operation will become clear only later. The Ministry of Finance publishes its intervention totals at the end of each month and a day-by-day breakdown each quarter, so in the meantime traders estimate the sums from the Bank of Japan's daily data on money-market balances. That delay is part of the tactic, since doubt about how much firepower was used, and how much remains, discourages speculators from testing the ministry again too soon.

How the carry trade works

The pressure on the yen comes from the gap in interest rates. The Federal Reserve's policy rate sits at 5.25 to 5.5 per cent, while the Bank of Japan lifted its own rate out of negative territory only in March, to a range of zero to 0.1 per cent. That leaves a wide spread for anyone who borrows in yen and invests in dollars. Hedge funds do it with leverage, Japanese life insurers and pension funds do it by buying foreign bonds, and Japanese households have joined in through overseas investment funds.

Every one of those flows means selling yen. Intervention works in the opposite direction: the ministry sells dollar assets held in its foreign-exchange reserves, and the Bank of Japan, acting as its agent, buys yen in the market. The sums can be large, but they are finite. Japan holds more than $1 trillion of reserves, which is plenty for occasional raids and far too little to offset a steady stream of private capital heading abroad for as long as the rate gap persists.

Winners and losers of a cheap yen

A weak yen is not all bad for Japan, which is one reason the government tolerated it for so long. Exporters such as carmakers have reported bumper profits, because overseas earnings are worth more once converted home. Tourism has boomed as foreign visitors find the country unusually cheap. The stock market has enjoyed a strong run, helped by those inflated earnings.

The costs fall on households and smaller companies. Japan imports most of its energy and much of its food, so a cheaper yen feeds straight into the prices of electricity, petrol and groceries. Real wages have fallen for many months in a row, which erodes public support for the government and puts pressure on ministers to be seen doing something. Intervention is partly that signal.

Why reserves are not enough

History is not encouraging for countries that defend a currency against the rate gap. The 1998 intervention worked partly because Washington joined in, which it has shown no appetite to do this time. The 2022 purchases looked effective in hindsight mainly because American yields peaked soon afterwards and the dollar turned. Intervention can smooth a move and punish speculators; it has rarely reversed a trend on its own.

The strongest counter-argument is that the trend may be about to turn anyway. If the Fed begins cutting rates in the autumn, as futures markets now expect, the rate gap will narrow from the American side and Tokyo's operations will look prescient. That is possible. The problem is that it leaves Japan's currency policy hostage to decisions made in Washington, and a single hot American inflation report could undo it.

What to watch

The Bank of Japan meets at the end of this month and has promised to set out a plan for reducing its purchases of government bonds. A firm taper, combined with a hint of another rate rise, would do more for the yen than any amount of intervention. A timid plan would invite traders back into the carry trade, particularly if American data firm up. The ministry's next move, if it comes, will again be timed to coincide with a data release that does part of its work.

Speculators took a beating, and they will be back. The yen will probably weaken again unless the Bank of Japan raises rates, since reserves cannot stand in for tighter monetary policy. If the central bank holds back at its July meeting, the currency is likely to drift back toward 160 within weeks, and Japanese households, not hedge funds, will pay the bill in dearer imports.