When Japan buys yen, it unwinds a dangerous trade

AMERICA’S TREASURY secretary, Scott Bessent, is used to making audacious bets against central banks. He once worked for Soros Fund Management, the hedge fund famous for “breaking” the Bank of England during the sterling crisis of 1992. But in late July Mr Bessent bet the other way, lining up alongside a central bank in defence of its currency. He dipped into America’s foreign-exchange reserves to help the Bank of Japan (BoJ) buy yen, which had weakened past ¥163 to the dollar for the first time since 1986.

Mr Bessent was not shy about his latest trade. In a cabinet meeting partly open to the press, he left a to-do list visible on the Camp David conference table: “Buy Japanese yen,” it said. His boss was also proud of the intervention. “We’re…very, very strong financially,” President Donald Trump proudly explained. “They wanted a little bit of help.”

Japan was no doubt grateful. But it would be wrong to think of it as a helpless naïf. On the contrary, in teaming up with Japan’s government, America was joining forces with one of the biggest currency traders of all time—an institution accustomed to making bets on a scale that would make any hedge fund tremble.

In its latest interventions the BoJ, acting on behalf of Japan’s finance ministry, may have spent more than $95bn, according to Reuters, a news agency. It sold the dollars for about ¥160 apiece. A big chunk of its reserves were accumulated when a dollar could be had for less than ¥100. In making the trade, therefore, Japan’s government was taking vast profits. Back-of-the-envelope arithmetic suggests it may have reaped as much as ¥5.7trn ($36bn). George Soros reportedly made about $1bn (worth some $2.4bn in today’s money) from betting against the pound.

The government’s cross-border holdings have been good for its finances. In their paper titled “What About Japan?”, YiLi Chien of the Federal Reserve Bank of St Louis, Harold Cole of the University of Pennsylvania and Hanno Lustig of Stanford University calculate that the government, the BoJ and Japan’s public pension funds together hold foreign assets worth more than 56% of GDP. Over the quarter-century to 2023 these assets earned average annual returns of 5.8% (only a fraction of which have been realised through trades).

What about the other side of the ledger? The public sector’s liabilities are chiefly in relatively low-yielding yen. The government sells bonds in its own currency, many of which have been bought by the central bank. The central bank in turn owes yen to the commercial banks which hold accounts with it. The public sector’s balance-sheet has thus benefited both from favourable currency movements and from the difference in yields between the foreign assets it owns and the yen liabilities it owes, known as the “carry”. “The sheer scale of Japan’s public sector holdings makes it the world’s largest carry trade investor”, as Mr Chien, Mr Lustig and Wenxin Du of Harvard University put it in another article.

The BoJ has been no less successful a carry trader for being an accidental one. The aim of its currency interventions over the past 25 years has not been to make money. It has instead sought to stabilise the yen and undo the exchange rate’s wildest misalignments. An uncomfortably strong yen hurt Japan’s exporters and worsened its deflationary tendencies after its asset-price bubble burst in the 1990s. An excessively weak yen, by contrast, raises the cost of food and fuel, most of which are imported.

For as long as Japan was fighting stagnant demand and deflationary pressure, its gigantic carry trade was sustainable. In those conditions, the central bank was always going to keep interest rates low and the yen weak. But underlying inflation has now increased and is close to the BoJ’s annual target of 2%. Several members of its rate-setting committee fear inflation will overshoot. Forecasters expect the committee to raise interest rates three times by July 2027. For the world’s largest carry trader, that is an awkward prospect. It would quickly raise the borrowing costs for Japan’s combined public sector by 0.75% of GDP, according to Mr Lustig’s figures, with more to come when longer-term liabilities are rolled over.

Keep calm and carry off

These dangers cast Japan’s intervention in a new light. With rate increases looming but the currency still dirt cheap, the government has picked an opportune time to prune its yen liabilities. By selling dollars and purchasing yen, it is, in effect, buying back some of the IOUs it has issued. And because Japan’s currency has yet to rally decisively, the BoJ can extinguish lots of yen liabilities for every dollar sold. With each such defence of the currency, the world’s biggest carry trade becomes a little less big.

The mechanics are a little involved. Any dollars the BoJ sells to commercial banks will drain their yen accounts at the central bank, reducing the amount the public sector owes to them. That is not the end of the story, for the BoJ’s interventions are typically “sterilised”: the central bank buys government securities from the banks (usually bills issued by the finance ministry) thus restoring their yen balances. But the net result is still that the exchequer, and therefore Japan’s consolidated public sector, has fewer yen liabilities to worry about.

This delicate pruning does not remove the dangers. If the purchases last month did amount to $95bn, they would have extinguished less than 1% of the public sector’s interest-bearing liabilities. But the intervention was nonetheless a well-timed step in the right direction. And judging by the currency market’s lack of conviction about the yen, the BoJ, with or without its American friends, may have several future opportunities to repeat the trade. “Buy yen” could remain on the Japanese government’s to-do list for a good while yet.■