Japan's FX intervention can't and won't work

Intervention works when it's a surprise and positioning is stretched - neither is true now

The chatter about official intervention to strengthen the Yen has picked up. There are two reasons why this intervention - if it happens - is doomed to fail. The first is about short-term considerations. Intervention works best when it’s a complete surprise and when positioning in FX markets is very stretched. Neither is true now. The second is about medium-term fundamentals and this is by far the more important factor. As I’ve been flagging in recent posts, Japanese long-term interest rates are far below where they would be if markets were allowed to set them. This means that risk premia due to Japan’s high public debt are being artificially suppressed in the bond market. As long as that’s the case, depreciation pressure on the Yen will continue. This explains why intervention in 2024 was unsuccessful in sustainably strengthening the Yen. There is a solution to this conundrum, which is for the government to sell some of its vast holdings of financial assets and use the proceeds to pay down debt. As long as that doesn’t happen, Japan is in denial and FX intervention just exemplifies that.

• Short-term reasons why intervention won’t do much: official intervention works best when it’s a complete surprise and positioning is extremely stretched. All the chatter on intervention means the cat is out of the bag, while positioning looks far from stretched. The chart below shows positioning in the CFTC’s weekly CoT report, which isn’t nearly as short Yen as ahead of official intervention in 2024. The last data point here is for January 20 and Yen shorts will have shrunk a lot further since then. That’s going to mute the short-term effectiveness of any intervention, if and when it happens.

• Medium-term reasons why intervention can’t work: the basic issue in Japan is that long-term government bond yields are being kept artificially low by the BoJ. As long as that’s going on, long-term yields can’t reflect the risk premia markets demand given the high level of public debt. The best way to see this is to compare Japan’s 30-year yield (JP), which is on the vertical axis in the chart below, with that of Germany (DE). Germany has far lower debt (horizontal axis), but the 30-year yield for both countries is the same. Japanese long-term yields are subject to de facto yield caps. That suppresses risk premia in the bond market, but those risk premia assert themselves in foreign exchange markets, putting depreciation pressure on the Yen. Intervention changes nothing about this and therefore has only short-lived effects, as the 2024 intervention shows.

There is of a solution. Japan’s gross public debt is 240 percent of GDP, but net debt is far lower at 130 percent. The difference is due to the financial assets the government owns. Those assets need to be sold and the proceeds used to pay down debt. That’s the best way to end depreciation pressure on the Yen. Even a small gesture here would in my opinion work wonders. This isn’t happening because of political economy. All those financial assets are managed by people who have a lot of influence and don’t want to sell them. That’s the hurdle that Japan has to overcome. The only way to get there in my view is for things to get worse before they can get better. That means more Yen depreciation until the influence of these vested interests is broken.