How the weak Yen pushes up US yields

Japan has to sell US Treasuries to get Dollars, which it needs to defend the Yen

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Japan is trapped. It’s caught between the need to keep long-term government bond yields low to avoid a debt crisis and a growing urgency to stabilize the Yen, which is in a devaluation spiral due to artificially low yields. I’ve proposed a way for Japan to get out of this dead end, which involves the government selling some of its financial asset holdings and using the proceeds to pay down gross debt. Even a small move in this direction would see markets react positively, with long-term yields falling and the Yen rising. Markets would reward the signal more than anything else: a radically different approach that breaks clearly from the past.

But that’s not happening. In fact, Japan is pretty much doing the opposite. Instead of confronting its debt overhang, it tries to paper over the growing cracks with periodic FX intervention to stop the Yen from falling to much or too fast. As I’ve flagged many times, this can’t possibly work because - in order to cap long-term yields - the Bank of Japan is constantly buying tons of government bonds, which means it’s doing QE and thus easing monetary policy. Monetary easing weakens a currency, so any intervention to strengthen the Yen can’t possibly work in this context.

Today’s post looks at how all this spills over to the global economy. Most obviously, it’ll be adding upward pressure to US Treasury yields because Japan will be selling Treasuries to get its hands on Dollars that it then sells to buy its own currency in the vain hope that this will stop the Yen from falling. At a time when there’s already lots of stress in government bond markets globally, Japan’s debt dysfunction is spilling over into global markets in the form of higher Treasury yields.

The blue line in chart above shows monthly purchases of government bonds by the Bank of Japan. It’s these purchases that cap long-term yields and put depreciation pressure on the Yen. The gray bars show Japan’s official FX intervention to support the Yen. The chart highlights two things. First, it’s shocking how large intervention was in May and how little effect it had. After all, the Yen has fallen back to where it was before this intervention within the space of only a few weeks. Second, the chart shows how the Bank of Japan and Ministry of Finance (which runs FX intervention) are working at total cross-purposes. This is government dysfunction at its finest.

What does this intervention mean for US Treasuries? The way intervention works is as follows. Official reserves are usually parked in highly liquid US Treasuries, which need to be sold to mobilize Dollars that can then be used to defend the Yen. The chart above shows this. The gray bars are the same data as in the first chart. I’ve just flipped the sign and converted the series into billions of Dollars. The blue line shows buying (+) or selling (-) of Treasuries by Japan in data from the US Treasury. Past episodes of intervention have coincided with Japanese selling of US Treasuries. The most recent episode will have done that too (we don’t have those data from the US Treasury yet), which will have been yet another factor pushing yields higher in May.

The US Treasury market is huge. Daily turnover is around $1 trillion. So it’s not obvious that Japan’s May intervention ($74 bn) will have driven yields higher single-handedly. But the associated selling of US Treasuries will have come on top of what was going on anyway, which was selling of Treasuries because of the war with Iran and mounting inflation anxiety. Japan’s policy dysfunction is spilling over into higher yields globally and this is happening at the worst possible time.