The Hidden Risk in the US-Japan Yen Rescue

0:00Life is all about making decisions. Sometimes you make questionable ones, like buying a new TV that's too big for the wall because the electronics store employee was a little too good at their job. Then sometimes you make great ones, like protecting your home and auto with Progressive. You get customized coverage options so you can be sure you have the right coverage. Get your quote today at Progressive.com. Progressive Casualty Insurance Company affiliates and other insurers not available in all states. This episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome?

0:35That's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50-page restoration block, or finally break down that long article you've had open for weeks. Gemini and Chrome is here for it. Ready to make anything online make sense? There's no place like Chrome. Check responses set up required compatibility and availability varies 18+. The United States government is now paying more to borrow money than it has in decades, and to understand why we have to start somewhere strange, with a currency operation the US hasn't attempted since 1998 and a photograph of a notepad.

1:12The notepad belonged to Treasury Secretary Scott Bessent, and at a cabinet meeting last month a Reuters photographer standing behind him got a clear shot of it. At the top of the page neatly underlined was the heading TO DO. Underneath it a single instruction, BUY JAPANESE YEN. He had thoughtfully included the currency code in brackets in case he forgot which yen. And below that the size of the trade, 5 to 10 billion dollars. Now I'm a big believer in personal productivity and there's something reassuring about watching the chief financial steward of the world's largest economy execute a$10 billion currency intervention with the same administrative system I use to run my own life.

2:01Buy yen, 5 to 10 billion, milk, eggs, take the autumn suits out of storage. A few days later, aboard Air Force One, reporters asked President Trump why the United States had stepped in to support Japan's currency. He explained it as an act of pure international goodwill.

2:40That is the President of the United States announcing a foreign exchange intervention. We will get to what one of those actually involves in a moment, but yes, he did bring up Pearl Harbour while describing a favour he was doing for Japan. There is a certain Basel Faulty quality to all of this, a sense that no matter how delicate the diplomatic situation, the administration can't get through a friendly chat about Japan without bringing up the war. Will you stop talking about the war? Me? You started it? We did not start it. Yes you did, you invaded Poland. I'll be honest, joint currency intervention sounds like the most boring thing in the world.

3:23It sounds like something that happens in a beige conference room in Basel, filled with people who own more than one calculator. And I say this as someone who does own more than one calculator, and I've always wanted one of the old hand-cranked mechanical ones too. But I digress. The point is that normally this stuff really is boring, and this time it isn't, because the US Treasury does not do this. The last time it stepped into the market to prop up the yen was 1998. So when it happens again after 28 years, it's worth asking why. And the why in this case involves a former Soros hedge fund manager now running the United States Treasury, who placed a very large bet that US interest rates would fall, and who is now doing some strange things to stop that bet from blowing up in his face.

4:19But before we get to what he did, we need to understand why the yen got into trouble in the first place. For the last few years, the yen has been sliding towards a 40-year low against the dollar, and the reason isn't especially mysterious. It comes down to a very large gap in interest rates. The Federal Reserve spent 2022 and 2023 raising American interest rates to around 3.75 % to fight inflation. The Bank of Japan, meanwhile, kept its interest rate at zero for years and only recently nerved itself up to raise it to 1%. So, you have one country where borrowing money is nearly free, and another where parking cash in government bonds pays you around 4%.

5:10And a gap like that is an invitation. It's the setup for what finance people call the carry trade. You borrow yen in Tokyo, where it costs almost nothing, sell the yen for dollars and put the dollars into something that pays more. US treasuries, European bonds, Korean tech stocks, whatever you like. Now, there's something odd about this trade. By rights, it shouldn't work at all. The textbooks say that a currency with a low interest rate is supposed to rise over time by exactly enough to cancel out the extra yield, so that nobody gets a free lunch. That's the theory. In practice, the yen has obligingly done the opposite for years.

5:56It kept falling while traders collected the interest, and the trade has paid beautifully. Economists have a name for this, they call it the forward premium puzzle, and they've been arguing about it for decades. The most popular explanation is that you aren't getting free money at all. You're being paid to hold a grenade. The carry trade works right up until the point where it doesn't, and when it stops working, it stops for everyone, on the same afternoon. Everyone rushes to unwind at once, the yen rockets and markets become very exciting for about 48 hours. So, the extra yield based on this view is just your fee for volunteering to be the one holding the grenade when the music stops.

6:45By some estimates this global carry trade has grown to over 4 trillion dollars, which is larger than the entire economy of India. All built on the back of low Japanese interest rates. So when people say the yen is the world's funding currency, this is what they mean. An awful lot of trades that look like they have nothing to do with Japan, a punt on Mexican bonds, a leverage bet on tech stocks, are somewhere underneath borrowing cheap yen to do it. Which means a great deal of the financial world is short the yen without thinking about it very hard, which is great unless you happen to live in Japan.

7:26A weak yen is a fine thing if you're a large Japanese exporter, but if you're an ordinary person in Tokyo, it's a disaster. Because Japan imports almost all of its oil, its natural gas and its raw materials. And when your currency falls, your energy bills don't stop to ask whether you enjoyed the export boom. They just go up. To show just how far out of line the exchange rate had gotten, Jeff Yu, a strategist at Bank of New York Mellon, came up with the Katsu Curry Index. For 40 years, The Economist has used its Big Mac Index to measure whether a currency is cheap or expensive, by comparing the price of a Big Mac around the world.

8:12You built the same idea on a different lunch, the price of a pork cutlet curry at Coco Ichibana, the largest curry chain in the world. Priced in katsu curry, a dollar should get you about 62 yen. In the actual market, it was getting you 159. By the curry standard, the yen was undervalued by something like 60%, which is wonderful news if you're an American tourist eating your way through Kyoto, and rather less wonderful if you're a Japanese restaurant trying to pay for imported frying oil. For what it's worth, the Economist's Big Mac Index agrees that the yen is far too cheap, though it reckons a dollar should buy about 80 yen, not 62.

8:58The trouble, as Yu points out, is that the Big Mac measures Japan using a food the Japanese don't eat all that much, of. It's a bit like gauging the British economy by the price of a burrito. You'll get a number, it just won't mean very much. This is, admittedly, a crowded field. There's already a Starbucks Latte Index and a KFC Index built specifically for Africa. Somewhere out there is an economist ready to price your currency in whatever franchise is nearest. Katsukuri is simply the latest recruit. Now, normally this is the point in the story where the American Treasury Secretary is supposed to express his sympathy, remind everyone that the United States believes in letting markets set exchange rates, and then do absolutely nothing.

9:48And I cannot stress enough how firmly that has been the rule. For decades, the official position of the US Treasury has been that it does not meddle in currency markets, that intervention is a short-term band-aid that mostly doesn't work, and that grown-up economies let the market decide what their money is worth. American treasury secretaries have spent years lecturing other countries for doing the exact thing Bessent is now doing. Twice a year, the treasury even publishes a report that keeps a watch list of the trading partners whose currency practices, generally interventions, in its word merit close attention.

10:32The most recent one came out in July. It has 10 countries on the list. Japan is one of them. So, in the same month the US Treasury was formally monitoring Japan over its currency, it was also in the market helping Japan move that same currency. Rules are rules, I guess. Now, a pedant might point out that the report scolds countries for pushing their currencies down to make their exports cheaper, and here the Treasury was helping Japan push the yen up. Which is true. Basent wasn't breaking the letter of his own report, he was just spending American money to move a currency he was simultaneously monitoring Japan form moving.

11:18Completely different, right? Which then brings us to the obvious question, why would he do this? Now, as I mentioned earlier, Secretary Besend wrote Buy Japanese Yen on his notepad, carefully adding JPY in brackets. Anyone who's worked on a trading desk will tell you that you don't trade JPY, you trade a currency pair, dollar yen or euro yen or sterling yen, you are always simultaneously buying one currency and selling another. Writing buy JPY on a trading ticket is a bit like walking into a restaurant and ordering food. Now, normally you'd expect a former Soros trader to know this, but as it turned out, leaving off the dollar half of the pair wasn't an oversight.

12:09He wasn't trading dollars at all. When the Federal Reserve Bank of New York executed the trade on July 31st on behalf of the Treasury, placing the orders through Goldman Sachs and Morgan Stanley, they didn't sell American dollars to buy yen, they sold euros, which came as quite a surprise to the European Central Bank, mostly because no one had bothered to tell them. Now, we won't know the exact mechanics until the Treasury publishes its official statement on August 30th. It's possible that they simply sold euro currency forwards, but as Toby Nangle pointed out on the Unhedged podcast, the bulk of the euro assets sitting in America's exchange stabilization fund are held in French government debt.

13:00So, there is a very real possibility that the US Treasury propped up the Japanese Yen by dumping a mountain of French government bonds without telling Paris or Frankfurt. Senior European central bankers were reportedly furious, describing the move to the Financial Times as an unprecedented breach of central banking etiquette. It is the financial equivalent of showing up at your neighbor's house, borrowing their car without asking, crashing it into a tree, and then calling them the next day to explain why their insurance premium is going up. It turns out the International Monetary Fund actually publishes a manual on foreign exchange intervention which specifically advises central banks against intervening in currencies that don't belong to them.

13:50So, that's one for the collection. Now, to be fair to Secretary Besant, this wasn't even his first time playing currency doctor. Late last year, he intervened to support Javier Millet's government by buying Argentine pesos. But the peso and the yen are, economically speaking, slightly different beasts. Bailing out Argentina is political favor-currying. Intervening in the world's third most traded currency, using someone else's money, is more of a statement. So, in his very first major reserve currency operation, the US Treasury Secretary managed to run a trade the IMF handbook explicitly warns against, while gate-crashing a central bank he hadn't invited to the party.

14:40And there's a wonderful irony to all of this. Before Scott Bessent took over the Treasury, he spent his career at Soros Fund Management. He was in the room in 1992 when Soros and Druckenmiller famously broke the Bank of England by shorting the pound, and a decade later he was back at it, betting against the Bank of Japan as it flooded the system with cheap money under Abenomics. Shorting the yen was one of the trades that made his name. Besant is a man whose entire reputation was built on betting against central banks that were trying to hold their currencies at artificial levels. And now he's sitting in Alexander Hamilton's old chair, using public money to defend a currency against 30-year-old hedge fund analysts running his exact old playbook.

15:33Somewhere in Mayfair, a young macro trader is looking at Besant's yen defense the way a young Scott Bacent looked at the Bank of England in 1992 and licking his lips. Which brings us all back to why he was doing it, because despite all the rhetoric about friendship, this was never really about being good to Tokyo, it was about protecting American borrowing costs. Japan is the single largest foreign holder of US government debt, with over a trillion dollars in treasuries. If Japan had to spend another 50 or 80 billion dollars defending the yen, it would have to raise that cash somehow, and the obvious way is to sell US treasuries.

16:18When you dump treasuries onto the market, bond prices fall and yields go up. To understand why that particular outcome kept Basen awake at night, you need to know about the bet he'd made with the nation's debt. When the US government borrows, it can borrow for the short term or for the long term, it can sell treasury bills which come due in a matter of months, or it can sell 30-year bonds and lock in the rate for a generation. For most of the last two years, Bessent has leaned hard on the short stuff, issuing bills rather than terming out into long bonds. There are respectable reasons to do this, but there's also a big bet buried inside it.

17:04The respectable reason is that long-term yields are a little high at the moment, and no treasury secretary wants to lock in a high rate for 30 years if he thinks that rates are about to fall. So, you could decide to fund yourself with short-term bills, keep your options open and wait. The bet is that if he thinks rates are about to fall apart, Bessent is in effect wagering that long-term interest rates will come down, at which point he can finally issue longer dated bonds on the cheap. This is the kind of directional bet you'd expect from a hedge fund, and Bessent of course ran one. It's a much stranger thing for a treasury secretary to be doing, because the Treasury Secretary's job isn't to speculate on interest rates, it's to fund the government.

17:56And it's worth asking whether it's a good bet, because a great deal rides on it. For most of the last century, interest rates of 4 or 5 % would have looked completely ordinary. The strange period, the truly weird one, was the decade after the financial crisis, when rates sat near zero. That was the anomaly, and percent is, in effect, betting the anomaly comes back. But here's the thing about near zero interest rates. In the entire history of the United States, they've happened exactly twice. Once after the 2008 financial crisis, and once when the economy seized up during COVID. That's the complete list.

18:41Rates don't go to zero because things are going well. They go to zero because something has broken horribly. So, a bet on rates collapsing back to those levels is, at its core, a bet that something breaks. But we should remember as well that he does have a mandate from his boss to do his best to keep rates as low as possible. The fundamentals to support lower interest rates aren't helping percent either. Inflation is still running above target, the US government is carrying near record debt relative to the size of its economy, and it is spending far more than it collects in taxes. If you are being asked to lend the American government money for 30 years, all of that argues for a higher interest rate, not a lower one.

19:33You don't hand out cheap long-term money to a heavily indebted borrower who is still running hot. There is even a name for the thing he is avoiding. For decades the Treasury's guiding doctrine has been regular and predictable. Issue steadily across every majority and don't try to guess where rates are going, because the Treasury Secretary is not supposed to be a bond trader. Besant is trading. He is funding the long-term obligations of the United States with short-term bills, which works beautifully right up until the time you have to roll those bills over at a higher interest rate than you paid last time.

20:14Anyone who sat through a banking crisis knows how that film ends. And the trouble with the whole bet is that it only works if rates actually fall. And rates have not been falling. Early last year, the 10-year Treasury yield was sitting around 4%. Things were so calm that Besant had asked the Financial Times, where the hell is the market risk? Well, it seems he found it. As Katie Martin put it in the FT, the market risk is now here. 10-year yields have climbed to around 4.6%, and 30-year rates have crossed 5 % for the first time since the global financial crisis. Partly, she notes, because doubts have crept in about the Federal Reserve's willingness to tackle sticky inflation.

21:06If Japanese selling pushed those yields any higher, American mortgage rates would jump, borrowing costs across the country would rise, and Bessent's bet that rates would fall would look very underwater indeed. And this all points at something bigger than one man's trade. trade. As Martin argues, the whole episode exposes an uncomfortable truth. For all the bluster on trade and defense and geopolitics, the United States needs the world to keep buying its bonds. It lives on borrowed money, on a scale that dwarfs other advanced economies. And it cannot afford for big foreign holders to stop buying, let alone start selling, which is exactly why Japan, sitting on a trillion dollars of treasuries, is a friend worth having.

21:59So, to keep Japan from having to sell those treasuries, Bissent publicly encouraged the Federal Reserve to upsize a backstop facility called FEMA, the Foreign and International Monetary Authorities Repo Facility. FEMA lets foreign central banks hand their US treasuries to the Fed as collateral in exchange for temporary dollar cash, without actually selling the bonds on the open market. The way it works is that Japan gets the dollars it needs to buy yen, the Fed gets the treasuries as collateral, and nobody has to sell a bond on the open market, because selling them might force everyone to admit what they're actually worth, or at least where 10-year treasury yields ought to be.

22:48It's a bit like refusing to open your credit card statement so the balance stays purely theoretical. As long as nobody sells anything, everything is fine. Meanwhile, President Trump was continuing his charm offensive. Who knows better about surprise than Japan? Why didn't you tell me about Pearl Harbor? Okay? Right?

23:16Life is all about making decisions. Sometimes you make questionable ones, like buying a new TV that's too big for the wall because the electronics store employee was a little too good at their job. Then sometimes you make great ones, like protecting your home and auto with Progressive. You get customized coverage options so you can be sure you have the right coverage. Get your quote today at Progressive.com. Progressive Casualty Insurance Company affiliates and other insurers. Not available in all states.

24:08setup required, compatibility and availability varies 18+.

24:20I'm trying to cheer her up you stupid crout! President Trump, as we saw earlier, described the intervention as an act of pure friendship, but afterwards Tom Berger, who served as a Deputy Assistant Secretary of the US Treasury in the 1980s, wrote to the Financial Times to point out that this was nothing new. He cited the 19th century French philosopher Alexis de Tocqueville, who observed that Americans rarely regard virtue as a selfless act. They tend to see it as something that conveniently benefits everyone, themselves included, which is a very highbrow way of saying, So, did any of this actually work?

25:06At first, yes. Over two days at the end of July, Japanese and American authorities threw something like 88 billion dollars at the market and the yen strengthened hard, around 5 percent, which is a very big move in currencies. It took fewer and fewer yen to buy a dollar, the rate pulling in from a 40-year low, near 164, towards 155. And then the loss of financial gravity reasserted themselves. Within two weeks, the yen had surrendered about half of that, weakening back past 159. Barry Eichengreen, writing in the Financial Times, pointed out that 88 billion dollars is ultimately small potatoes against the sheer scale of the currency market.

25:56In ordinary life, 88 billion dollars is real money. In the foreign exchange market, where trades worth trillions change hands every day, it's a rounding error. Maurice Obesfeld at the Peterson Institute has a word for the deeper problem. He calls the administration's approach cakeism. The belief that America can chase a pile of contradictory goals all at once and never pay for it. Washington wants a weaker dollar but no inflation. It wants low borrowing costs but enormous deficits. It wants Japan to keep buying its bonds while helping Japan make the yen stronger. You can want all of those things, but you can't have all of those things, and sooner or later the bond market sends you the bill.

26:46And here's the part that turns cakeism from a contradiction into a genuine farce. Some of the yen's weakness, the problems that Basen is supposed to be trying to solve, are being caused by Washington's policies. As Obesfeld points out, the administration's own trade policy is pushing the yen down. The tariffs make Japanese exports more expensive in America, which weighs on the yen. And the trade deal that Japan signed commits it to pour hundreds of billions of dollars into US investment and to send that money to America. Japanese investors have to sell yen and buy dollars to do this, which pushes the yen down further.

27:31So, the United States is spending reserves to prop up a currency that its own trade policy is helping to sink. It's a man bailing water out of a boat that he's also enthusiastically drilling holes in. Which brings us to the gravity underneath the whole story. And it isn't only America's problem. It's a trap with two countries standing in it. The United States needs the world, and Japan in particular, to keep holding its enormous pile of dead. Japan needs a stronger yen, and the two of them can't both get what they want, unless somebody somewhere raises interest rates. To see why America's side of that is getting harder, look at what happened this week.

28:18On Thursday the US Treasury auctioned$25 billion of 30-year bonds, and had to pay a yield of 5.22 % to get them sold. That is the highest borrowing cost on a 30-year bond since August 2001. The night before that, a$42 billion sale of 10-year notes went at the highest yield since 2007. The market is charging the United States more to borrow than it has in a generation. There's an academic paper that explains why this is happening, by Professor Wenxin Du at Harvard and her co-authors. It's about something economists called the Treasury Convenience Yield, which is a fancy name for a simple idea. For decades, the world was willing to accept a lower return to hold US government debt, purely because it was the safest, most liquid asset on the planet.

29:14Everyone wanted Treasury, so the US got to borrow a little more cheaply than anyone else. That discount was the reward for being special. What Du and her co-authors have found is that the discount has been shrinking for years and has recently vanished and even gone negative. And the reason is almost embarrassingly simple. Supply. The US government has issued so much debt for so long that its bonds just aren't scarce or special anymore. When you flood the market with something, it stops being precious. So, the free money the United States used to get for being exceptional is draining away, and that 30-year auction is what the draining looks like in real time.

30:03And this is exactly why Basent is so nervous about Japan. If your bonds have stopped being magically special, and your single largest foreign customer starts selling them, your borrowing costs rise. So, the clean way out of the trap is for Japan to fix it at the source by raising its own interest rates, which would strengthen the yen without anyone having to touch a single treasury. Bank of Japan governor Ueda knows inflation has climbed above 2 % and the bank has signaled more hikes are coming, but Japan's new prime minister is deeply averse to higher borrowing costs. She'd rather reflate the economy with fiscal stimulus, which is a bold plan for a country whose debt is already more than 200 % of its economy and where servicing that debt already eats up a quarter of government spending.

31:01And Ueda has some uniquely Japanese history weighing on him. Gillian Ted recounted in the FT that on a visit to the Bank of Japan an official gestured at the portraits of two former governors and noted evenly that both men were assassinated after controversial monetary experiments in the 1930s. So, you can understand a certain caution in Tokyo. It's hard to concentrate on the finer points of yield curve policy when contemplating your own life expectancy. But here is the thing about intervention. It doesn't change the trend. It buys you a few days, a week maybe, until the underlying gap between the US and Japanese interest rates reasserts itself and the yen resumes its slide.

31:52Which leaves us with two possibilities, and I honestly don't know which is right. The first is that Scott Bessent is a visionary. He can see something the bond market can't. That inflation is about to come under control, that confidence in American debt is about to return, and that long-term interest rates are therefore about to fall, properly and durably. If he's right, he gets to term out the nation's debt at bargain rates, and this whole nervous period looks, in hindsight, like a brilliantly timed hold. The second is that he's a day trader who's taken an enormous directional bet with the balance sheet of the United States, betting on a fall in long-term rates that no one really controls.

32:39Those rates answer to inflation and to investor trust, not to percent and not even to the Federal Reserve, which only sets short-term rates. In the meantime, he's selling other people's euros and pawning Japan's bonds to hold the line. The bond market, for what it's worth, just charged the United States the most it's paid to borrow for 30 years since 2001. Make of that what you will. Thanks for listening to the podcast. If you really enjoy it and you'd like to support it directly, the best way is through Patreon. The link is in the show notes and it really does help keep this going. Thanks to everyone who already does and I'll talk to you again soon.

33:24Bye.

33:27Progressive's Accident Response can contact Emergency Services if you're in a major accident. The only thing worse than someone you love being in an accident is not being able to help them. So Progressive is here to help when you can't. So get peace of mind knowing your loved ones are protected with Progressive's Accident Response. Learn more at Progressive.com. Progressive Casualty Insurance Company and Affiliates. Limited availability in California. Driver is responsible for emergency and towing charges not covered by the policy. Coverage subject to policy terms and conditions. Brussels clean up nicely at Sweetgreen.

34:01Maple glazed, roasted, and edges perfectly caramelized. Sweetgreen's fall harvest is back on the menu, and the season's most overlooked little green vegetable is dressed to be devoured. You know what to do. Order on the Sweetgreen app.