By Mike Dolan
LONDON (Reuters) – If the Japanese government is thinking ahead, it may be planning to rein in the volatile yen rather than support it.
A two-year cat-and-mouse game between speculators and Japanese authorities — which involved increasing bets against the yen because of widening interest-rate gaps with other Group of Seven economies — ended this month with the cat licking its lips, even as it suffered from some indigestion.
The yen’s slide to its lowest levels in nearly four decades, which played a big role in the exit of another Japanese prime minister this week, has led to months of government warnings and then periodic bouts of yen-buying intervention by the Bank of Japan.
But when the Bank of Japan finally raised interest rates again on July 31 and warned of further hikes, it burst the carry trade bubble and the currency turned violent – sparking a short-lived spasm of stock market volatility in Tokyo and around the world.
Is the mission completed?
There is an opinion that it may end up being somewhat successful.
If we go back to long periods of recent history where the Bank of Japan either bought or sold the yen every two to three years to adjust its movements, it is very likely that the currency would quickly overtake the yen again to the strong side.
Nomura, Japan’s largest brokerage, did not say it had raised the possibility before last week’s explosion.
“We may need to start studying possible foreign exchange interventions by the Ministry of Finance to curb the yen’s strength rather than weaken it,” the bank’s macroeconomic research team told clients on Aug. 2, adding that this was not its “base case” yet.
“The history of intervention tells us that after yen buying interventions, yen selling interventions were followed with the aim of reducing the yen’s excessive strength.”
tendency to overdo
And until about 10 years ago at least, this was the routine swing of the pendulum.
The most famous instances of currency intervention were the G5 and G7 collective invasions of 1985 and 1987 – with the Plaza Accord to weaken the dollar, followed two years later by the Louvre Accord to support the dollar. The dollar/yen was at the heart of these swings.
But yen interventions by Japanese authorities saw official buying and selling of the yen at extreme levels of between 150 and 75 yen to the dollar every few years over the two decades following the property market crash of the 1990s.
The extreme levels of low interest rates in Japan since that crash, and the resulting inflation and deflation in speculative trading, paved the way for volatility and excesses in both directions during that period.
The usual “dip” was a weaker yen, and the “flow” was exaggerated rebounds in times of stress or volatility, as carry trades exploded, or Japanese investors fled their overseas investments. This was one of the main reasons the yen acted as a safe haven during any market shocks in that period – exacerbating the moves in the mix.
But after the Great Financial Crisis of 2007-08, there followed a decade in which interest rates in almost all G7 countries approached zero in Japan – stifling the temptation of carry trades and allowing the yen’s relatively stable exchange rate to effectively neutralize the Bank of Japan’s hyperactive currency desk.
In fact, there was no definite intervention between the extraordinary earthquake and tsunami shock of 2011 and 2022 – when interest-rate spikes elsewhere after the pandemic and the invasion of Ukraine left Japan locked at zero again – that reignited the carry trade in the deal.
The wild volatility of the past few weeks is just a reminder of the currency’s inherent tendency to overshoot its limits.
Natural yield gaps?
It is not hard to see where the yen might come from here. With interest rates in the US and other G7 countries falling, and the carry trade disappearing, Japan may feel emboldened to “normalize” – increasingly confident that its decades of deflation since 1990 are over.
Although markets now think Tokyo may be more cautious about raising interest rates again for fear of upsetting the stock market as it did earlier this month, the latest GDP update may be encouraging, a new prime minister will be in town soon, and the US Federal Reserve is likely to start cutting rates next month anyway.
Benchmark two-year Japanese bond yields have fallen below 30 basis points from a 15-year high of nearly 50 basis points at the start of the month. Given this alone, any suggestion of a rate hike would justify a significant repricing.
But the yield gap with the rest of the G7 is already starting to narrow.
The two-year Treasury spread has fallen by 1.1 percentage points in just three months, and the dollar/yen did not react to this shift until three months later. It would take another 1.7 percentage points of this spread to return to the 10-year average – and that could happen relatively quickly if it comes from both sides.
Fears of Donald Trump’s pledge to impose sweeping trade tariffs if the former US president wins the Nov. 5 election may be another reason Japan is holding off on attacking China for a while. But Trump is no longer the favorite in opinion polls or betting markets.
While any further move to raise interest rates could be partly damaging if a stronger yen hits exporters and the broader Japanese economy, the flip side of a stronger currency is lower import prices, allowing for greater increases in real wages to achieve the ultimate goal of growing domestic consumption.
But if the yen’s strength rises too much and too quickly, there will always be intervention to calm it down.
The views expressed here are those of the author, a Reuters columnist.
(By Mike Dolan X: @reutersMikeD; Editing by Paul Simao)