Scott Bessent’s Yen Trade Has Unintended Consequences for the Markets
The way it’s being done should make us worry that the Fed is being roped into easing monetary conditions when it should be moving to tighten them
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The joint U.S.-Japan support of the yen is unusual. The way it is being financed is unprecedented, and adds liquidity when the punch bowl of the U.S. economy and markets is already overflowing.
Put simply: America is printing dollars so Japan can buy yen. It isn’t quite quantitative easing, because the Federal Reserve is lending Japan money in return for temporary ownership of Treasurys in repurchase agreements, rather than outright buying the Treasurys. But like QE it expands the Fed balance sheet and pumps billions of dollars into the economy.
So far the scale is small, but Treasury Secretary Scott Bessent wants the Fed to drop its $60 billion cap on the emergency facility being used—or abused, given there’s no emergency—to lend to Japan, and pledged to do “whatever it takes” to help.
When the Fed is widely thought to be moving toward raising rates, this is exactly the opposite of what it should be doing. Expanding the balance sheet is also the opposite of what Chairman Kevin Warsh has repeatedly said he wants to do.
All that said, is it a bad idea?
Start with the yen, which is seriously weak. In June it dropped to its weakest against a basket of trading partners and adjusted for inflation in data going back to 1970. Japan, which imports most of its energy, is facing a double whammy of the higher oil prices that affect everyone and even higher prices in yen terms as the currency plumbed new depths.
A weak currency doesn’t justify intervention on its own. But the yen has also been behaving oddly.
In just over two years the Bank of Japan has raised rates five times, while the Fed has cut rates six times, narrowing the gap between the interest available in the different currencies from 5.6 percentage points to 2.75 points. The gap between 10-year U.S. Treasurys and Japanese government bond yields has dropped from a 2023 high above 4 percentage points to below 2 points.
The “carry trade” of selling yen and earning interest on the money in dollars should have become less attractive as policy rates converged, strengthening the currency. But it continued to work because traders shifted to focus on 2-year bond yields, where the gap widened a bit this year amid a cautious tone from the BOJ and expectations of Fed rate rises.
Crucially for those putting on the trade, the yen weakened without much volatility, and speculative bets against the yen ramped up to reach far and away their highest in Commodity Futures Trading Commission data back to 2010.
Heavy speculative positioning can result in messy outcomes when it suddenly reverses, swinging global markets violently as speculators are forced to cut borrowing in unrelated areas. Just this sort of thing led to the 2024 carry trade reversal, when a hawkish Bank of Japan and weak U.S. jobs figures resulted in sudden cuts to yen carry trades, a 12% one-day plunge in the Japanese stock market and big falls in U.S. and European stocks.
Nathan Sheets, global chief economist at Citigroup, a former Fed Japan specialist and undersecretary of the Treasury for international affairs, says it makes sense to try to reduce the risk of a “sharp nonlinear correction” (economist-speak for plunging markets).
But the way the U.S. intervened suggests Bessent is trying to avoid the standard method of intervention where Japan sells some of its stock of Treasurys, putting upward pressure on yields.
“The U.S. authorities were worried about potential implications of this for the Treasury market if it had been done in a more traditional way,” Sheets said. “Bessent’s saying here that he’s watching the U.S. Treasury market very closely and as a corollary that there are some potential tail risks that he needs to manage.”
The problem with intervening by lending dollars to Japan is it makes the intervention less likely to work. Printing dollars to finance the intervention avoids higher Treasury yields and eases monetary conditions—adding fuel to the stock rebound since Situational Awareness blew up last week—both of which work against the stronger dollar Japan wants.
Indeed, the yen has weakened a bit from near 155 to the dollar about three days ago, to almost 158 to the dollar, from a weak point of 164 before the intervention.
The real measure of effectiveness is whether the intervention forces the market to reconnect the yen’s level against the dollar to the interest rate gap between the U.S. and Japan. The surest way is for the BOJ to be clear that more rate rises are imminent.
Intervening now makes some sense, but the way it’s being done should make us worry both that the Treasury is concerned about a hidden problem in government debt, and that the Fed is being roped into ease monetary conditions when it should be moving to tighten them.
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