What is going on with the Japanese yen?

On August 1, the US and Japan conducted a coordinated FX intervention to support the value of the yen. FX intervention is not unusual when it comes to the yen – Japan’s Ministry of Finance (MOF) has officially conducted interventions from September to December 2022, and throughout 2024, defending the value of the yen.

The more unusual bit about the latest bout of intervention is the involvement of the US.

So, this piece is to look at the big questions, why is the yen so weak, why intervene, why is the US helping, how do interest rates fit into the picture and what to look out for when assessing the outlook for Japan, dollar/yen and interest rates.

Why so weak?

The Japanese yen has generally trended lower, ever since late 2020. Probably the biggest factor behind this move has been divergence in interest rate policy. While central banks elsewhere were abandoning bond purchases or quantitative easing and lifting interest rates in response to pandemic-induced inflation, the Bank of Japan (BOJ) began normalising policy much later, and only first hiked rates in 2024.

Relatively low interest rates in Japan means that it becomes more attractive invest in assets elsewhere, where interest rates and expected returns are higher. Additionally, its also made borrowing in Japan popular, so combined, these activities put downward pressure on the yen.

But in the past few years, there have been other factors driving down the yen. With inflation emerging in Japan and the BOJ beginning to increase interest rates, the interest rate differential between Japan and the US has actually declined over the past year or so, diverging from the yen.

That means there must be other factors explaining yen weakness.

Part of the story is that the BOJ has been limited in how much or how quickly it can raise rates. The BOJ has been ultra cautious (the overnight policy rate only sits at 1.0%), and especially since a big sell-off in risk back in July 2024, when BOJ Governor Ueda hinted that a rate hiking cycle was beginning.

At the time, the yen appreciated sharply, but also equities sold off sharply in Japan and the US. With changes in Japan’s policy rates impacting big investment flows, significant increases in the BOJ policy rate could lead to major dislocations in financial markets. The BOJ also has an additional incentive to be cautious – after years of pinning bond yields at zero and the BOJ purchasing big chunks of Japanese government bonds, the bond market still isn’t functioning like a normal market. Liquidity remains low, although market functioning has improved according to a recent survey conducted by the BOJ.

But there have been two other developments in recent times helping keep the yen weak:

1) Election of Takaichi as PM: Takaichi’s policy direction has been overwhelmingly expansionary - increasing government spending, increasing defence spending and cutting taxes. Japan’s budget position isn’t necessarily in an unsustainable position, but it does worsen Japan’s budget deficit at a time when inflation has come back along with growing investor worry about debt sustainability.

2) The supply shock to energy from the Iran war: Because Japan imports a significant amount of its energy needs, the current energy shock, which could potentially worsen, affects Japan more than others. As a result, Japan’s trade balance and current account has swung into deficit, which tends to be negative for a country’s currency.

Does FX intervention work anyway?

Japanese intervention has worked in the short-term, and the threat of intervention may keep the yen stronger than otherwise would be the case. With the US in the picture, the clout of possible intervention is bigger. But fundamental reasons, such as what the Bank of Japan will do, and economic conditions tend to be the big drivers of currency moves. The major episodes of yen appreciation over the past few years have been because of rate hikes, and expectations of rate hikes from the BOJ. Not so much intervention. Take a look at the chart below, where you can see that the yen strengthen substantially around rate changes (circled), much more so then when the MOF intervened.

But also notice that the timing of rate hikes occur not long after yen intervention. This is not a coincidence. The weaker the yen gets, the more it poses an inflation risk and the more likely the BOJ will hike rates.

It’s really about interest rates

But as mentioned before, there is good reason for the BOJ to be reluctant in raising rates too quickly given the potential disruption to financial markets.

It’s also no secret that Trump wants lower interest rates. If the current US administration cares about interest rates and global share markets, it has a stake in what happens in Japan as well. It’s not so much a bailout of Japan but to assist in keeping the global monetary taps flowing. Because if the yen continues to depreciate, the more likely interest rates in Japan go up, which means interest rates in the US will go up too. Moreover, higher interest rates in Japan means that the more likely the big money parked overseas, in the US will find a reason to bring that money back to yen.

In the lead up to the August 1 intervention, the US Federal Reserve left interest rates on hold at their meeting earlier that week, although longer-term bond yields rose. You can read more about that here: https://bitesizedeconomics.substack.com/p/everybody-loves-ray-tes-on-hold.

But the Bank of Japan also met and announced on the day of intervention that they would too, be leaving rates on hold.

BOJ Governor Ueda was typically cautious about signalling much about raising rates anytime soon. Moreover, those on the monetary policy committee at their previous meeting in June, saw that “downside risks to production and employment appear to be greater than the upside risks to prices”.

But also that:

“Import prices have also been driven up by exchange rate developments. Such price increases are considered to place a burden on the business of a considerable number of firms, including small and micro firms. Against this backdrop, it has become more appropriate than before to adjust the degree of monetary accommodation.”

As much as the BOJ may be hesitant in raising interest rates further, financial markets may end up forcing the BOJ’s hand. If the joint FX intervention between the US and Japan fails to prop up the yen, higher interest rates will still likely come, because of the inflation risk from the weaker currency.

Even if the BOJ doesn’t act on policy rates, longer-term interest rates may end up rising anyway, if investors feel like inflation is on the rise, or if concerns continue to mount about the scale of fiscal spending. A 370 trillion yen ($2.3 trillion) plan from the Takaichi’s government could add to these concerns, especially if we continue to hear little detail on how this investment will be funded.

It really comes down to inflation

The problem is not that Japan’s government finances are unsustainable, it’s that Takaichi’s fiscal expansion comes at a time when inflation risks are high. Bigger government spending puts further upward pressure on inflation, and interest rates.

But the key inflation risk really hinges on the current energy shock. The world has found some mitigating factors keeping crude oil prices below $100 a barrel – increased production elsewhere, rerouting around the Strait of Hormuz, weaker Chinese demand and the release of strategic reserves. However, there remains significant uncertainty about how long the energy shock will last and still risk it could worsen.

What happens next?

Compared with yen interventions in 2022 and 2024, there are different factors driving yen weakness now.

Today, it isn’t just an interest rate story, there are growing concerns about Japan’s fiscal position plus a deteriorating trade position given Japan’s dependency on offshore energy. Japan’s MOF may have the US helping the out with intervention, but it’s a difficult, if not impossible job through intervention alone. There’s a number of factors pushing against them, which means that intervention is likely to occur again. Successful support for the yen beyond the short-term may only come from BOJ rate hikes. And even then, BOJ rate hikes may also not be enough to prop up the yen, if we see no resolution to the Strait of Hormuz or a substantial workaround and energy markets remains stressed. An alternative is that the BOJ changes course and lifts rates more aggressively, but given Japan’s past actions, more intervention is likely to come first. If we do see bigger strains in energy markets, the BOJ could be pushed to hike more substantially anyway.

Higher inflation would put pressure on Takaichi to back down on some of her spending plans, although there appears no sign of her doing so at the moment, and again, depends heavily on whether the energy shock can be resolved.

Japan isn’t necessarily in crisis, but recent developments have highlighted some big vulnerabilities in Japan’s economy, Japan’s offshore energy dependency and high government debt levels and the hangover from ultra-low interest rates for such a long time. And it wouldn’t be just Japan that would be hurting.