Japan's policy doom loop sends yen to 40-year low

As Japan's yen sinks to its lowest in 40 years, Tokyo's policy credibility in the eyes of international investors appears to be sinking too. The dollar/yen rate, the world's second most traded currency pair, is now above 163.00 for the first time since 1986. Why is Japan's currency so weak? Partly it is dollar strength. Most major currencies have weakened against the greenback in the last few months as a second wave of the global energy shock has reignited inflation fears, pushing up U.S. Treasury yields. While most developed market government debt has come under selling pressure, Japanese government bonds (JGBs) are particularly exposed - Japan imports around 90% of its energy, with 95% of that coming from the Middle East. But the yen's troubles run deeper, and Tokyo's options for addressing them are limited. The yen failed to get a lift when crude oil prices tumbled 45% over May and June. And seemingly 'yen-positive' proposals from Tokyo, like the recent announcement encouraging Japanese pension funds to invest in domestic financial assets, have also failed to boost the currency. There's always currency market intervention, and the Ministry of Finance has conducted several bouts of yen-buying since 2022, most recently a $73 billion splurge three months ago. In total, the MOF has spent around $215 billion in efforts to stop the yen's decline. These actions have bought time, but they have not engineered a lasting revival. Robin Brooks, senior fellow at the Brookings Institution in Washington, goes even further. He says Japanese bond yields would likely be in the double digits were the BOJ not capping yields with its vast JGB purchases. The BOJ is slowing, or 'tapering', its bond purchases, but is still hoovering up 2.6 trillion yen ($16 billion) of JGBs each month. Can Japan reduce its debt burden? Japan has trillions of dollars of domestic and overseas assets, which Brooks says it can sell to reduce its gross debt. These include FX reserves, assets held by the Government Pension Investment Fund (GPIF), the world's largest pension fund, and domestic equity holdings. But there appears to be little political appetite in Tokyo for that, and officials may look at the huge FX intervention since 2022 - more than $200 billion of dollar-denominated deposits or assets sold to support the yen - and decide against it. Certainly, the prospect of GPIF and other large pension funds potentially buying more domestic assets hasn't impressed investors much. “The efficacy of intervention is really falling. That’s telling – the market is saying something needs to change, and I don’t think the government has understood that,” Brooks says. To be fair, some recent developments working against the yen can't be blamed on Japan. Oil is back above $90 a barrel, up 30% in the last three weeks due to escalating military actions between the U.S. and Iran. The two-year U.S.-Japanese yield spread has widened to 285 basis points, the widest since last August, partly driven by expectations that the Federal Reserve is on course to deliver two rate hikes by the first quarter of next year. But the yen's fate ultimately lies with Tokyo. And right now, investors are cutting it very little slack. What this all suggests is that the world has taken a particularly dim view of Japan's current policy mix: the fiscal stance is too loose, monetary policy is not tight enough, and as ever with Japan, the coziness between the two is stoking market concerns about the Bank of Japan's independence. Japan appears to be stuck in a policy “doom loop,” with few available exits. On the fiscal side, Prime Minister Sanae Takaichi's plans for aggressive spending to stimulate the economy have not been cheered by markets, which is understandable given that the country's gross debt-to-GDP ratio remains well over 200%, by far the highest in the world. Japan has held that dubious record a long time, but with the public finances already in such a dire state, the lack of clarity on how Takaichi plans to fund the government's share of a projected 370 trillion yen ($2.28 trillion) in combined public and private investment through fiscal year 2040 is particularly unnerving. That discontent has helped push the 10-year JGB yield up to 2.90%, the highest in 30 years. The BOJ has raised its policy rate to a 31-year high of 1%, but that is still paltry relative to its G10 peers, and in real terms, it remains deeply negative. Many investors say the BOJ is behind the curve, so it's perhaps little surprise that short-dated U.S.-Japanese bond yield spreads have moved significantly in the dollar's favor. Morgan Stanley's chief Japan economist Takeshi Yamaguchi met with U.S. institutional investors during a trip to the States earlier this month. He wrote on Tuesday that many expressed concern that Takaichi's substantial fiscal expansion would be inflationary. Tellingly, while a small number argued that Japan's fiscal situation isn't so bleak, when asked whether they would buy long-term JGBs at current levels, their answer was nevertheless “no.” The risk premium offered by JGBs is still too small relative to the fiscal uncertainty.

Japan's policy doom loop sends yen to 40-year low

Yen falls to lowest level in 40 years

Intervention loses force as yield spreads widen

Markets question Japan's fiscal and monetary mix

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