What's happening in the markets?
The holiday period is over, and tensions have immediately flared up again: Japan and the US had intervened in the currency market to prop up the yen. This currency has fallen well below purchasing power parity, leaving many of Japan's trading partners feeling they are facing unfair competition from Japan.
Moreover, this situation does not suit Japan either, since Japan has to import large quantities of raw materials, particularly oil and gas. Prices for these in dollars have risen sharply over the past period, but in yen even more so. This is pushing Japanese inflation up considerably. The Bank of Japan has therefore already been raising Japanese interest rates for some time. However, Japan carries very high levels of debt, so the Bank of Japan is extremely cautious about raising rates further. The central bank is terrified of hitting the monetary brakes too hard and thereby tipping the economy into crisis.
This is precisely where the yen's exchange rate runs into trouble. The yen is already distrusted internationally anyway, because the current Japanese government wants to increase the budget deficit while keeping interest rates low. If the central bank were to accommodate this latter wish, it would in effect amount to pursuing an inflationary policy. This distrust of the government, combined with the wish from all sides to keep Japanese rates low and in any case prevent them from rising quickly, keeps pushing the yen's exchange rate down. This is especially true when rates in the West are rising rather than falling. And that is exactly what is happening now.
The end result is that, until recently, the yen remained under downward pressure. Yesterday the yen's exchange rate did rise considerably, but it is still too early to say whether this marks the beginning of a much larger appreciation of the yen.
Japan therefore continues to threaten further currency intervention. This, however, terrifies Washington. Japan holds an enormous amount of dollars, but these are largely invested in US government bonds. It could well be the case that, if Japan wants to support the yen further through intervention, it would first need to sell dollar bonds on a large scale in order to obtain sufficient dollars. Washington is therefore terrified that the sale of US bonds by Japan would push long-term US interest rates even higher. This is why Bessent is putting heavy pressure on Tokyo to raise Japanese interest rates quickly. In response, Japanese long-term rates have already risen sharply.
For the Bank of Japan, this is in turn an extra reason to raise short-term rates only slowly. It is therefore understandable that tensions between Tokyo and Washington are escalating. For now, the result of all this is that the interventions and the threat of further intervention have done little to help the yen's exchange rate. For this to have more effect, US rates would need to fall and Japanese rates would need to rise quickly. Neither is particularly likely:
- capital market rates are rising across the entire world;
- government deficits remain far too large;
- there is an investment boom around AI, with the companies involved borrowing increasing amounts of money;
- due to ageing populations, savings are steadily declining;
- because government deficits remain high, more and more investors fear rising inflation in the future;
- capital flows from non-Western countries towards Western countries are diminishing; countries such as China and Saudi Arabia no longer dare to hold as much of their reserves in the West;
- Western central banks bought up enormous quantities of bonds during the Covid crisis; this is no longer happening;
- rising energy and food prices are adding further fuel to the fire.
Another factor is that the dollar has a tendency to strengthen anyway, including against the euro. This is due, to begin with, to rising oil and food prices, to which the European economy, and also the Japanese economy, is far more sensitive. Furthermore, rising energy and food prices are pushing up long-term rates in the US and Europe by roughly similar amounts, which means that US rates will remain considerably higher. This is therefore, in principle, favourable for the dollar's exchange rate against the euro (and the yen).
