The Yen Should Be Rising. Its Failure to Do So Is Exposing Japan’s Trillion Yen Debt Trap

The yen is behaving in a way that should worry Tokyo. Japan has intervened repeatedly to support it, Japanese bond yields have risen and the interest rate gap with the United States has begun moving in Japan’s favour. Yet the currency remains weak. A more uncomfortable possibility is emerging: markets may be beginning to doubt whether Japan can raise interest rates far enough to defend its currency without making its enormous government debt progressively more expensive.

Something unusual happened in the currency markets this week. Softer American inflation data reduced expectations for further Federal Reserve tightening and pulled United States short term yields lower relative to Japanese yields. For years the opposite movement had helped explain the yen’s decline because money could be borrowed cheaply in Japan and invested at much higher rates in America. As that gap narrowed, the yen should have received some relief. Instead, it remained weak.

That distinction matters because the behaviour of a currency can be more revealing than its absolute price. A yen falling while American rates rise tells us little that we did not already know. A yen that struggles to recover when American rates fall relative to Japanese rates suggests that another force is beginning to dominate the market.

The signal from the currency

Japan has already tested the obvious remedy. Around the turn of April and May, the Ministry of Finance bought 11.735 trillion yen in three interventions, including 6.279 trillion yen on April 30 alone. The operations moved the currency sharply, but the effect did not endure.

THE MARKET SIGNAL For much of the yen’s decline, the story was straightforward. United States yields stood far above Japanese yields, encouraging investors to borrow yen and buy higher yielding dollar assets. Recently the relationship has become less comfortable. American rate expectations are falling, the United States Japan short rate gap is narrowing, Japanese yields are rising, and the yen is still weak. The important development is therefore not merely that the yen has fallen. It is that some of the conditions that should support it have begun to return without producing the expected recovery.

For several years the carry trade offered a convincing explanation. Japan kept money extraordinarily cheap while the Federal Reserve raised rates aggressively, allowing investors to borrow in yen and move the proceeds into higher yielding assets elsewhere. That explanation has not disappeared, but if the interest rate disadvantage diminishes while the yen remains weak, something else must increasingly be determining its price.

The other interest rate

The explanation may lie partly in Japan’s government bond market. Japan accumulated one of the world’s largest public debts during three decades of exceptionally low inflation and exceptionally low interest rates. The Bank of Japan reinforced that system through immense purchases of government bonds and remains an extraordinary presence in the market even as it slowly retreats.

This raises a question that has become more important as inflation has returned. What would Japan actually have to pay to borrow if the Bank of Japan were no longer such a dominant buyer?

There is no reliable number. Claims that thirty year Japanese government bond yields would necessarily rise to seven or ten per cent without central bank support go beyond the evidence. Japan also borrows overwhelmingly in its own currency, possesses immense financial assets and remains one of the world’s largest external creditors.

But the direction of the distortion is easier to establish than its size. The Bank of Japan itself accepts that years of enormous purchases affected the functioning of the government bond market. It has therefore been reducing those purchases, allowing private investors gradually to play a larger role in setting long term rates.

That creates the possibility of a second interest rate alongside the one visible on a trading screen: the higher return private investors might demand if the central bank withdrew much further. The yen may already be reflecting uncertainty about where that rate lies.

The constraint Japan cannot easily escape

This produces a different interpretation of the yen’s weakness from the familiar carry trade story. The problem may no longer simply be that Japanese interest rates are too low. It may be that markets increasingly question whether Japan can comfortably raise them high enough.

Japan’s central government owes more than a quadrillion yen. Higher rates do not produce an immediate fiscal crisis because the debt has a long maturity and therefore reprices gradually. Yet as old bonds issued during the era of negligible interest rates mature, they must be replaced at today’s higher borrowing costs. The pressure accumulates slowly, which makes the danger less like a cliff than a tightening screw.

JAPAN’S POLICY CONSTRAINT Raise rates: the yen becomes more attractive, but higher borrowing costs gradually feed into an enormous government debt stock. Hold rates down: government financing remains easier, but Japanese assets remain less attractive than foreign alternatives and the yen can weaken. Buy more government bonds: the central bank can restrain yields, but increases its already immense influence over the market. Intervene in foreign exchange: Japan can force the yen higher for a time, but repeated interventions have not established a lasting change in direction. The authorities can shift financial pressure between the currency and bond markets more easily than they can eliminate it.

Higher Japanese yields should support the yen, but sustained higher yields eventually increase the cost of servicing the government’s debt. Holding rates lower protects the fiscal position but leaves Japanese assets less attractive, while renewed central bank purchases risk recreating the distortions from which the authorities are trying to escape.

The strongest case against the argument

There is a simpler explanation for much of what has happened, and it should not be dismissed. Japan has been hit particularly hard by the Middle East energy shock because it imports almost all the fossil fuel it consumes.

More expensive energy worsens Japan’s terms of trade, transfers income overseas, raises costs for companies and households and contributes to domestic inflation. That combination can naturally produce higher Japanese bond yields alongside a weaker currency without requiring any hidden fiscal crisis.

Nor is Japan comparable with a conventional sovereign borrower approaching default. Its debt is overwhelmingly in yen, much of it is held at home or by the central bank, and the country owns enormous foreign assets. Any claim that Japan is approaching an ordinary sovereign debt crisis would overstate the evidence.

WHAT WOULD DISPROVE THIS THESIS? If energy prices fall, the United States Japan interest rate gap continues narrowing and the yen then appreciates substantially, the simpler explanation will have won. The recent weakness could then be understood mainly as the product of the carry trade and an exceptional external energy shock. The more troubling case arises if those pressures ease and the yen still fails to recover. At that point the market would be signalling that something more structural is being priced.

When a Japanese problem becomes an American one

Japan’s defence of its currency does not occur entirely within Japan. The country accumulated enormous foreign reserves during decades of intervention, including large holdings of dollar assets and United States government securities.

The process can now work in reverse. Supporting the yen requires Japan to sell foreign assets or foreign currency and buy yen. Not every intervention requires an immediate sale of long dated Treasury bonds, but sufficiently large and persistent operations can make one of America’s largest foreign creditors a seller of dollar assets at the margin.

Washington itself faces very large financing requirements, so a prolonged Japanese currency problem has a route into the world’s most important government bond market.

The bargain that sustained Japan

Japan’s predicament has its origins in an arrangement that worked for decades. Negligible inflation permitted negligible interest rates, which made an enormous government debt affordable and allowed the Bank of Japan to accumulate bonds on an extraordinary scale without destroying confidence in the currency.

The return of inflation and the energy shock have disturbed that equilibrium just as the Bank of Japan is reducing its footprint in the bond market, after decades in which the state and financial system adapted themselves to extraordinarily cheap money.

There is no reason this process must end in crisis. Lower energy prices would improve Japan’s external position, while falling American rates could narrow the interest rate gap without forcing the Bank of Japan to do all the work. Japan’s external wealth, savings and long debt maturity also give Tokyo considerable room for manoeuvre.

For years the yen could largely be understood as the casualty of the difference between Japanese and American interest rates. That explanation is becoming less satisfactory as the differential moves in Japan’s favour without producing the expected response.

The market may instead be asking whether Japan can sustain both the interest rate its currency requires and the interest rate its enormous government debt can comfortably bear. If those two rates are diverging, the yen is becoming the place where a much larger tension in Japan’s financial system is expressed.

That is why this week’s movement matters. Conditions that should have helped the yen finally arrived, yet the currency remained weak. The question is what the market is now demanding from Japan before it will allow the yen to rise.

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