Brad Setser on the US's Unusual Japanese Yen Intervention

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1:30Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, I think I know the answer to this question, but do you ever write to-do lists? No. Yeah. I figure. No, I'm not. No. Well, I make a half-hearted attempt every day where it's like podcast recording one, podcast recording two, do the newsletter, reply to the following emails. Yeah. But as of last week, I have seen the most epic to do list. Oh, yes. Yes. Presumably. Yeah. Yeah. Yeah. I saw the Scott Besson to do list. It was basically like by the end. Right. Right. So U.S. Treasury Secretary Scott Besson.

2:14there was a photo taken of him. Presumably he did this on purpose. One would hope, but he had a to-do list and it basically just said, buy Japanese yen. And he put in the JPY acronym. So there's no ambiguity. Five to 10 billion. Yeah. So it was pretty clear that he was not referring to personal purchases in some vacation. If that's the only thing on the treasury secretary's to-do list, he's not that busy, right? He's not, but he presumably is fairly busy. We know that the yen had been weakening dramatically. We know that there has been a recent sharp strengthening. There's always talk of a yen intervention here and there.

2:52I don't really understand fully why the yen is so weak, why the U.S. feels compelled that it's important to get involved in that market, etc. I have many questions. Yeah. So the U.S. did intervene together with Japan in the yen to stop it from weakening. And what's really interesting about all of this, I mean, we love big foreign currency stories anyway, but what's interesting is this was kind of a new type of intervention. So the U.S. actually sold euros, which was very interesting. And they also used a Fed repo facility that I had completely forgotten about as well. So there are all these interesting questions about this particular incident, let's say, including the big one, which is, will this be enough to stop the yen weakening?

3:37and it's still very surreal to me whenever I look at a chart of the dollar exchange rate the yen will always be 110 to the dollar for me because that was my allowance when I was there I got a thousand yen every week and it was like roughly ten dollars and so I have that stuck in my head and whenever I look at the chart it's now at like 155 it's kind of crazy yeah no it's pretty wild I mean for so long for like the first half of our careers the story was like strengthening and strengthening yen, lower and lower rates at the long end of the Japanese yield curve. People used to talk about the widowmaker trade because many people had gone short various forms of Japanese paper on the expectation that it'll blow up in some way.

4:21But it has really blown up, but it's been quite a reversal on both the rates and the yen. And again, the question I have in addition to the tools is, why is this an important thing now for the U.S. to get involved and why do we feel? So I have many questions. All right. So whenever we have big questions about capital flows or FX moves, we shine our Brad Setzer bat signal into the sky and he magically appears on the podcast. So we do in fact have the perfect guest. We are speaking once again with Brad Setzer, senior fellow at the Council on Foreign Relations. So Brad, thank you so much for coming back on All Lots.

4:56It's always fun. Maybe just to begin with, let me ask the obvious question. If your currency is weakening to the degree that you think an intervention is necessary, why doesn't the BOJ, the central bank, just raise rates? That is a very obvious question. For whatever reason, the Bank of Japan has been very slow to raise rates. So the short-term policy rate is about 1%. Inflation is clearly above that. There are different measures. Inflation has been above that for a long time. The stated reasons for the hesitation is, you know, the Bank of Japan has worked for so long to get inflation back to two.

5:41They don't want to prematurely cut off this shift in behavior to kind of they don't want to fall back into the zero rate, zero inflation economy. I think there's also probably a few technical reasons. I'm sure that Ueda wanted the yield curve to steepen, and it has a lot, before short-term rates went up. And, you know, short-term rates affect the cost of all the yen deposits. So they impact the liability side of the banking system. The banks have a lot of low-yielding assets on their balance sheet. So does the Bank of Japan. So there may be some concern about pushing up the cost of funding on the banking side too fast.

6:26the theory of some in the market, not me, is that this is out of concern about how it impacts the government's overall funding costs. And if you pushed up short-term rates, that would push up the fiscal deficit and interest costs too much. I think that's a little overstated, but that is certainly one of the considerations. I want to ask about why the yen has been so weak in the first place. But actually, before that, maybe we zoom out bigger because weakness in East Asian currencies in general has been a story of 2026. And, you know, it's not obvious to me why East Asian currencies at all would be particularly weak these days, because all I ever read about in headlines is extraordinary, you know, current account surpluses, not in Japan per se.

7:16The Korean one. The Korean specifically would be the big one. It's not intuitive to me at all that at a time when like the big chip makers are making money hand over fist, that they would be particularly weak currencies. Why do you give us this sort of view from the Asia Pacific view generally, and then the Japan specific view on this year's currency moves? Well, look, you're right. The global trade surplus is now all in East Asia. The chip, basically San Francisco decided to spend a lot of money on kit that basically comes from, you know, in the first instance, Japan, Korea and Taiwan, but feeds into a lot of parts from Japan.

7:57It's pushing, you know, it's helping China, too. So, you know, we have like really record trade surpluses throughout Asia, East Asia, except for Japan. We'll get to Japan later. And like, you know, Korea's current account surplus is going to go from 100 billion and change to somewhere between three and 400 billion. Massive. You know, Taiwan's is probably going to double. And, you know, it was big to begin with. So we're doubling means going from like 15 to 25 to 30 percent of GDP. These are insane numbers. With Taiwan, it's a bit different. The central bank doesn't want its currency to strengthen.

8:37And it has engineered a weakening of the Taiwan dollar compared to last year by reversing prudential regulations, basically letting the lifers unhedge their foreign assets. And then with Taiwan in particular, it's almost one company, TSMC. And you can kind of lean on that company to tell it when it converts and when it doesn't. Bloomberg actually did one of the best stories I've ever seen about the Central Bank of China, Taipei, and how it is managing Taiwan's dollar without actually using its balance sheet. Korea is different. Korea has been strange. It's been this story where the better the news is for Korea, the more the Korean stock market goes up, the more foreign holders of Korean stocks have to sell because they're hitting concentration limits.

9:24And that has created a weird situation where good news for the equities, for Korea's equity, so, you know, Hynix and Samsung, was leading to an outward flow and producing record weakness in the Korean won. That is layered on to outflows from the pension system. That is layered on to this whole story about, you know, Korean day traders used to buy levered U.S. ETFs, single stock ETFs. And then Korea let them buy levered single stock Korean ETFs. And that didn't turn out to be a great idea. But, you know, it's sort of we end up with a world where you have this enormous positive terms of trade shock, enormous, that is producing record weakness.

10:06And that's in the it's in that context where we can think about the yen as being another of these country currencies that is, you know, kind of fundamentally OK. Japan has a current account surplus of five percent of GDP. It's investment income. It's not trade. Its trade accounts would be improving but for oil, thanks to the AI stuff. It's got one of the biggest foreign asset portfolios in the world. The government of Japan has, you know, still probably close to$1.2 trillion in reserves. That's a big number. It has$900 billion plus in the government pension fund, foreign assets. That's a big number.

10:45GDP is now down to$4 trillion. So, you know, the government is sitting on a foreign asset position of close to 50 % of its GDP. The weakness has been throughout Asia a bit counterintuitive, but for slightly different reasons. And with Japan, you obviously have the very low rate story as a central part of it.

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12:02I'm not in a position to be inheriting any classic cars for you. No, but my brother did inherit my non-classic car when I moved to New York. So he still has not paid me for it. Coming for you, Joey. The Bloomberg This Weekend podcast. Subscribe today on Apple, Spotify or wherever you listen. So when I hear the words currency intervention, I often associate that with currency speculation. Right. And here central banks will come out and say, like, oh, stern words to the speculators. You better watch out and that sort of thing. With Japan, do we have indication of how much of this is actually speculation versus, to your point earlier, like actual outward investment?

12:52There's a bit of speculation around the yen. You know, there's not a clean measure of the speculative flow. But like, you know, look, the yen was one of the lowest yielding currencies. So it was a typical funding currency. I don't think the carry trade was on an enormous scale, but there were certainly hedge funds, others who more or less thought that the Ministry of Finance was going to allow the yen to weaken beyond what it had weakened before. And since, you know, You know, the yen, shorting the yen is positive carry. There's a higher yield on dollars than on yen. As long as it's stable, you make a little bit of money.

13:36And if the yen depreciates, you make a lot more money. So there was a bit of speculative betting on it. Not a ton, I would say. And then you have weird hedging dynamics. So there's a little bit of a dynamic where when the Nikkei goes up, foreigners holding the Nikkei need to hedge a bit more because some do partially hedge. When the NASDAQ goes up, the GPIF doesn't hedge, so it doesn't generate an offsetting hedging flow. And then despite all the hedge America stories from last year, in Japan, the key fixed income hedged investors seem to have gone a little bit less hedged. The life or hedge ratio has come down.

14:14So a lot of it is not quite your classic speculative flows, although there's a bit of that. A lot of this is hedging flows amongst real money investors. So that does add a little bit of a different dynamic. But I don't discount the fact that a bunch of investors, including a bunch of hedge funds, were basically making a bet that the yen would go to 170 because Ueda was behind the curve. So let's talk about it from the U.S. perspective. What is the reason that the weakening of the yen is something that would or should concern the Treasury Department? it? Well, I think the classic concern, which hasn't been the concern that Secretary Besant has articulated, is that extreme weakness in East Asian currencies gives East Asia a trade edge over American producers.

15:08I mean, classically, a weak yen is bad for Detroit. A weak Korean won is bad for Detroit. It's really, you know, the traded goods pressure, most classically through the automotive sector that has been the traditional driver of this. And to be clear, we are like, you know, the wands come back a bit, but 1500 is a crisis level of the one and Korea is not in a crisis. 160 is an insanely weak yen on any Big Mac index. It pushes the yen below in inflation adjusted terms where it was in the 1970s. We're back to the 1960s. These are extreme undervaluations, in my view. And so in that sense, the classic concern would be that this gives all these guys a huge edge over American manufacturers.

15:58That hasn't been what Besson has emphasized. He's emphasized, well, the weekend is putting pressure on the lawn, is adding to this generalized malaise, bizarreness, where good news is bad news for a lot of Asian currencies. And then there's a sense that this could create pressure on the treasury market. Now, to be clear, if the yen just falls, that makes the value of Japanese investments in treasuries higher. So the impact on the treasury market would come if the Japanese resisted that, use their reserves and the excessive use of their reserves or the use of their reserves started to put pressure on the treasury market because they have to fund, they would fund it by selling treasuries.

16:43So I think part of Besant's theory of the case is that by joining with the Japanese, first of all, you know, we're supporting the yen from an incredibly weak level. It's arguably overshot. It has decoupled from five-year, 10-year rate differentials for the past several months past year even. And by helping the Japanese, we're helping a friend. That's what the president says. And we can jointly intervene in a way that reduces the possible pressure on the treasury market. That would be, I think, the explanation I would give. But Besant hasn't been, he's more, I mean, the president said it was to help a friend.

17:24Besant has said it's to avoid destabilization throughout the Asia currency complex. Why did they do it in euros? Or why did the U.S. do it in euros? They sold euros. I mean, you know, some of it is just Secretary Besant being a former currency trader wanting to have presumably a bit of fun. You know, just getting creative. We have euros. We can't use euros. We have a few more dollars, but only a few more dollars. I mean, you can debate. I mean, this was clearly an intervention. But, you know, when you shift the composition of your reserves around, sometimes that's not even viewed as intervention because you're not selling your currency to buy another guy's currency.

18:02I think he presumably did it because he wanted to be a bit cute and say, well, this is not a view about the dollar. We still want a strong dollar. This is just a view about the yen. And we're just expressing this in a way that makes it clear that this is a view about the yen. It also let him do like kind of surprising things. Like there was the rate check in euro yen, which caused a lot of confusion in the market. But at the end of the day, we don't know the volume. We don't know if you actually did the five to 10. Maybe we'll see in a week or so. But the vast bulk of the intervention was from Japan's Ministry of Finance, and it was in dollar yen.

18:43So fundamentally, this was a dollar yen intervention, not a euro yen intervention. Brad, you mentioned that if you were to go by something like the Big Mac index, the dollar yen or the yen is at historically weak levels. And of course, there's all kinds of attempts to measure what fair value of a currency is, right? So you mentioned the Big Mac index, and then there's beer models and rear models and exchange rate differential models and GDP differential models. Do any of them work anymore? Are any of them consistently either predictive or useful? What is the state of all of these sort of classical approaches to determining fair value of any given currency?

19:31The Big Mac Index is a version of purchasing power parity that sort of prices, broadly speaking, should be the same if you're at comparable levels of development. Recently, particularly vis-a-vis Asia, the market pressure, the financial pressures have pulled currencies further away from their purchasing power parity levels. So that hasn't, as a predictive variable, that hasn't worked. As an analytical tool, I still think it's valuable. A behavioral equilibrium exchange rate model fundamentally looks at policy settings today and says, what's the impact of the policy settings? And then it says we don't know what the equilibrium value of the currency is, but we know what it is, where it has been in the past.

20:17So given the policies and given the past, is the currency strong or weak? All the Asian currencies kind of score as weak on this because they are fundamentally incredibly weak. I mean, we haven't talked about China, but China has a big and growing trade surplus. Use a current account based model. You'll find that China's currency is undervalued. Certainly Korea's currency is undervalued on a current account based model. All these show is undervalued on behavioral exchange rate based models. So basically, like what we know is that financial flows have pulled currencies quite far away from any of the more fundamental or purchasing power based measures.

20:57So I want to go back to the idea of avoiding additional pressure on the U.S. Treasury market. And a big component of this seems to be use of this Fed facility that I mentioned earlier. It's called the Foreign and International Monetary Authorities Repo Facility, very catchy, or FEMA. And it basically allows foreign central banks to use their treasuries as collateral to get dollars. But from what I understand, and I should say this facility, I think, came about during 2020, during the pandemic with the big treasury market route. From what I understand, it charges above market rates for central banks.

21:40And so one of the criticisms I've seen lately or maybe concerns is that the FEMA repo facility is ultimately going to be uneconomical for central banks. Like, why would they want to use it if they could just repo treasuries at cheaper market rates? And then secondly, the facility is also capped at something like$60 billion. So if you need to intervene again, someone's going to have to raise that limit. What are the sort of pros and cons of using this particular facility in this way? You're a fan, right? I'm a fan. I publicly, I privately pushed for it back when I was at the Treasury. I publicly pushed for it in 2020.

22:21I think it is a useful tool. The basic idea is that central banks have a lot of really good collateral. and if they need cash, they don't actually have to go and sell the treasuries into the cash bond market. They can just repo them at the Fed, get dollars, and then intervene that way. And it's zero risk to the Fed. And the Fed can always offset any monetary impact with its domestic operations. So there's no necessary monetary impact. It's just a way to allow, in times of stress or times of pressure, a central bank to avoid having to immediately sell treasuries. And remember that in 2020, we kind of got into a downward spiral in the treasury market where central bank sales were sort of begetting private sales and the long bonds was really selling off and the Fed had to come in and do a lot of direct bond purchases.

23:18So, you know, it sort of makes sense to have this additional tool in the toolkit. You know, why do it with the Fed rather than with it? Well, first of all, I guess, you know, the Fed is not in this case is a little quieter as a counterparty. I mean, it is disclosed, but with a weak lag is in theory. You know, if you get rid of the cap, it's unlimited in the quantities. And then the premium is there. It's not huge, but you can debate where it is. It was not meant to be used as a substitute for repo in ordinary conditions. So it does have a premium. I think you can argue that right now, if you're the Ministry of Finance and you got a legacy five-year bond with a pretty high coupon, you're better off using FEMA repo than dumping it in the market.

24:09You're going to be able to cover the cost of FEMA repo out of the coupon on the bond. And obviously, if you sell the bond, you're never going to get that bond at that yield back. It gives the Ministry of Finance a bit of flexibility. At a minimum, it means it can intervene and then sell treasuries with a lag. It doesn't have to sort of immediately sell. Now, Japan does have a cash buffer. When they've intervened in the past, for whatever reason, they haven't used their cash buffer. They've pretty directly sold treasuries. So I think, you know, it just gives another tool to the Ministry of Finance and gives the Ministry of Finance more options about how it generates the dollars that it's selling.

25:11Is there anything stopping Secretary Besant from saying, you know what,$150,$150 end of the dollar, that is our line in the sand. We're not going to let it weaken beyond that. And then you might not even have to spend a penny because, you know, no one's going to, people might not want to test it. And you just say, we have unlimited firepower because we're spending our own currency. We're just going to cap it there. Yeah, there is something that limits Secretary Besant from doing that, which is that he doesn't control the Fed's balance sheet. OK. Secretary Besant just has the ESF. Now, the ESF has ballpark 20 billion in FX, ballpark 20 billion in like liquid dollar cash.

25:52And then the special drawing rights, which it has like 160, 170 billion of a lot, but not unlimited. And using the special drawing rights is kind of even more out there than using FEMA repo. You know, it's sort of so, you know, the Treasury on its own probably doesn't have the firepower. Now, you can argue that between the Treasury, the MOF, if Japan could, through some magic, change some of the pension funds operating guidance so that it started hedging its$950 billion portfolio, there's more than enough firepower there collectively to set a target, sort of a yield curve control type target, 150, probably be more like 160 now.

26:41and thereby implement that. So, you know, whatever it takes, this is going to stay below 150 or 160. The world does change. Oil shocks happen, inflation shocks. The Fed may be raising rates. People think the Bank of Japan is likely now to raise rates. So I think the risk on that is that you get locked into defending a level and then the world changes. But, you know, conceptually, you could try to do that. I think what the Ministry of Finance is trying to do is reestablish fear in the market around 160. I mean, that used to be kind of a level where, you know, if you were going to go short the yen, you'd be a little nervous that the moth might come in and whack you.

27:23But then when they didn't defend 160. It's like the mafia whacking you, right? I mean, look, the weak side of the yen has been defined by the Ministry of Finance for the past several years. I mean, that's a conventional view in the market, given that the interest rate differential favors the dollar. By the way, we should discuss fiscal policy because U.S. fiscal policy is way worse than Japanese fiscal policy. So I don't buy this fiscal fears or whatever. It is rate differentials. But the rate differential has favored the dollar. And the limit for the past, I would say, three years on how weak the yen gets has been set by the MOF.

28:02And when the moth didn't intervene at 160 and then the last time it intervened at 162, you know, people thought, well, maybe they're going to allow further moves and we'll make a bet that the moth is going to tolerate a weaker yen, given that Ueda has been slow to raise rates. And so I think this is fundamentally about saying we're going to defend 160. There's a lot of risk around 160. Be careful if you want to just go short yen when you're close to that level, which is a softer version of the we're just going to defend 150 to kingdom come. All right. Well, on that note, perhaps the biggest question other than, you know, why did all of this happen is, is it going to work?