Brad Setser on the US's Unusual Japanese Yen Intervention

Last week, the US joined forces with Japan to try to stop the yen’s slide. It’s the first time the two sides have intervened in the Japanese currency in 15 years, and in many ways it was an unprecedented and unusual move, with Treasury Secretary Scott Bessent choosing to sell euros (as opposed to dollars) and the use of a little-known Federal Reserve repo facility. So why did the yen’s value drop so precipitously in the first place? And will this intervention be enough to stop it? Brad Setser, senior fellow at the Council on Foreign Relations, explains why the Bank of Japan initially refrained from raising rates, why East Asian currencies (not just the yen) have been so weak lately, the improving fiscal outlook for Japan, and what to look out for next. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Tracy Alloway?

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• 2:02Tracy Alloway?

  Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

• 2:06Joe Weisenthal?

  And I'm Joe Weisenthal.

• 2:08Tracy Alloway?

  Joe, I think I know the answer to this question, but do you have a write to do list?

• 2:13Joe Weisenthal?

  No.

• 2:13Tracy Alloway?

  Yeah. I figure.

• 2:16Joe Weisenthal?

  No, I'm not, no.

• 2:17Tracy Alloway?

  Well, I make a half-hearted attempt every day where it's like podcast recording one, podcast recording two, do the newsletter, reply to the following emails.

• 2:26Joe Weisenthal?

  Yeah.

• 2:27Tracy Alloway?

  But as of last week, I have seen the most epic to do list.

• 2:33Joe Weisenthal?

  Oh, yes, yes.

• 2:35Tracy Alloway?

  Presumably you saw this.

• 2:36Joe Weisenthal?

  Yeah, yeah, that I saw the Scott Besson to do list. It was basically like by the yen, right?

• 2:41Tracy Alloway?

  Right. So US Treasury Secretary.

• 2:43Joe Weisenthal?

  It's a pretty awesome to do list.

• 2:44Tracy Alloway?

  Scott Besson, there was a photo taken of him. Presumably he did this on purpose. One would hope, but he had a to do list and it basically just said buy Japanese yen. And he put in the J P Y acronym.

• 2:59Joe Weisenthal?

  No ambiguity.

• 2:59Tracy Alloway?

  Five to 10 billion.

• 3:02Joe Weisenthal?

  Yeah. So it was pretty clear that he was not referring to personal purchases in some vacation.

• 3:07Tracy Alloway?

  If that's the only thing on the Treasury Secretary's to do list, he's not that busy, right?

• 3:13Joe Weisenthal?

  He's not, but he presumably is fairly busy. We know that the yen had been weakening dramatically. We know that there has been a recent sharp strengthening. There's always talk of a yen intervention here and there. I don't really understand fully why the yen is so weak, why the US feels compelled that it's important to get involved in that market, et cetera. I have many questions.

• 3:33Tracy Alloway?

  Yeah. So the US did intervene together with Japan in the yen to stop it from weakening. And what's really interesting about all of this, I mean, we love big foreign currency stories anyway. But what's interesting is this was kind of a new type of intervention. So the US actually sold euros, which was very interesting. And they also used a Fed repo facility that I had completely forgotten about as well. So there are all these interesting questions about this particular incident, let's say, including the big one, which is will this be enough to stop the yen weakening? And it's still very surreal to me whenever I look at a chart of the dollar exchange rate. The yen will always be 110 to the dollar for me.

• 4:18Joe Weisenthal?

  Oh, yeah, yeah.

• 4:19Tracy Alloway?

  Because that was my allowance when I was there. I got a thousand yen every week and it was like roughly $10. And so I have that stuck in my head. And whenever I look at the chart, it's now at like 155. It's kind of crazy.

• 4:31Joe Weisenthal?

  Yeah. No, it's pretty wild. I mean, for so long, for like the first half of our careers, the story was like strengthening and strengthening yen, lower and lower rates at the long end of the Japanese yield curve. People used to talk about the Widowmaker trade because many people had gone to short various forms of Japanese paper on the expectation that it'll blow up in some way. But it has already blown up, but it's been quite a reversal on both the rates and the yen. And again, the question I have in addition to the tools is why is this an important thing now for the US to get involved? And why do we feel so? I have many questions.

• 5:06Tracy Alloway?

  All right. So whenever we have big questions about capital flows or FX moves, we shine our Brad Setser bat signal into the sky and he magically appears on the podcast. So we do in fact have the perfect guest. We are speaking once again with Brad Setser, Senior Fellow at the Council on Foreign Relations. So Brad, thank you so much for coming back on Odd Lots.

• 5:28Speaker 05

  It's always fun.

• 5:29Tracy Alloway?

  Maybe just to begin with, let me ask the obvious question. If your currency is weakening to the degree that you think an intervention is necessary, why doesn't the BOJ, the central bank, just raise rates?

• 5:46Speaker 05

  That is a very obvious question.

• 5:49Speaker 05

  For whatever reason, the Bank of Japan has been very slow to raise rates. So the short-term policy rate's about one, well, it is 1%. Inflation's clearly above that. They're different measures. Inflation's been above that for a long time. The stated reasons for the hesitation is, you know, the Bank of Japan has worked for so long to get inflation back to two. They don't want to prematurely cut off this shift in behavior to kind of, they don't want to fall back into the zero rate, zero inflation economy. I think there's also probably a few technical reasons.

• 6:29Speaker 05

  They, I'm sure that Ueda wanted the yield curve to steepen, and it has a lot before short-term rates went up. And, you know, short-term rates affect the cost of all the yen deposits. So it's a, they impact the liability side of the banking system. The banks have a lot of low yielding assets on their balance sheet. So does the Bank of Japan. So there may be some concern about pushing up the cost of funding on the banking side too fast. The theory of some in the market, not me, is that this is out of concern about how it impacts the government's overall funding cost. And if you pushed up short-term rates, that would push up the fiscal deficit and interest costs too much.

• 7:14Speaker 05

  I think that's a little overstated, but that is certainly one of the considerations.

• 7:19Joe Weisenthal?

  I want to ask about why the yen has been so weak in the first place. But I actually, before that, maybe we zoom out bigger because like weakness in East Asian currencies in general has been a story of 2026. And, you know, it's not obvious to me why East Asian currencies at all would be particularly weak these days. Because all I ever read about in headlines is extraordinary, you know, current account surplus is not in Japan per se.

• 7:47Tracy Alloway?

  With the Korean one, yeah.

• 7:49Joe Weisenthal?

  Specifically would be the big one. It's not intuitive to me at all that at a time when like the big chipmakers are making money hand over fist, that they would be particularly weak currencies. Why do you give us this sort of view from the Asia Pacific view generally? And then the Japan specific view on this year's currency moves?

• 8:09Speaker 05

  Well, look, you're right. The global trade surplus is now all in East Asia.

• 8:15Speaker 05

  The chip, you know, basically San Francisco decided to spend a lot of money on kit that basically comes from, you know, in the first instance, Japan, Korea, and Taiwan, but feeds into a lot of parts from Japan. It's pushing, you know, it's helping China too. So, you know, we have like really record trade surpluses throughout Asia, East Asia, except for Japan. We'll get to Japan a little later. And like, you know, Korea's current account surplus is going to go from 100 billion and change to somewhere between 3 and 400 billion. Massive. You know, Taiwan's is probably going to double. And, you know, it was big to begin with. So doubling means going from like 15 to 25 to 30% of GDP.

• 8:57Speaker 05

  These are insane numbers. With Taiwan, it's a bit different. The central bank doesn't want its currency to strengthen. It has engineered a weakening of the Taiwan dollar compared to last year by reversing prudential regulations, basically letting the lifers unhedge their foreign assets. And then with Taiwan in particular, it's almost one company, TSMC. And you can kind of lean on that company to tell it when it converts and when it doesn't. Bloomberg actually did one of the best stories I've ever seen about the Central Bank of China Taipei and how it is managing Taiwan's dollar without actually using its balance sheet.

• 9:41Speaker 05

  Korea is different. Korea has been strange. It's been this story where the better the news is for Korea, the more the Korean stock market goes up, the more foreign holders of Korean stocks have to sell because they're hitting concentration limits. And that has created a weird situation where good news for the equities, for Korea's equity, so you know, Hyunix and Samsung, was leading to an outward flow and producing record weakness in the Korean won. That is layered on to outflows from the pension system. That is layered on to this whole story about, you know, Korean day traders who used to do buy levered US ETF, single stock ETFs, and then Korea let them buy levered, single stock Korean ETFs.

• 10:26Speaker 05

  And that didn't turn out to be a great idea, but you know, it's sort of, we end up with a world where you have this enormous positive terms of trade shock, enormous, that is producing record weakness. And that's in the, it's in that context where we can think about the yen as being another of these country currencies that is, you know, kind of fundamentally okay. Japan has a current account surplus of 5% of GDP. It's investment income, it's not trade. Its trade accounts would be improving but for oil, thanks to the AI stuff. It's got one of the biggest foreign asset portfolios in the world. The government of Japan has, you know, still probably close to 1.2 trillion in reserves, that's a big number.

• 11:11Speaker 05

  It has 900 billion plus in the government pension fund, foreign assets, that's a big number. GDP is now down to 4 trillion. So you know, the government is sitting on a foreign asset position of close to 50% of its GDP.

• 11:25Speaker 05

  The weakness was, has been throughout Asia a bit counterintuitive, but for slightly different reasons. And with Japan, you obviously have the very low rate story as a central part of it.

• 11:53Joe Weisenthal?

  There are some market stories where you want every detail. Tracy and I have made quite a few podcasts on that basis, but sometimes you've only got 10 minutes and need to know what's moving markets and why. That's the Barclays Brief Podcast. Every week, experts from Barclays Markets and Research get you up to speed on what matters and what to watch next. About the time it takes to grab a coffee, so search Barclays Brief wherever you get your podcasts.

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• 13:54Tracy Alloway?

  So when I hear the words currency intervention, I often associate that with currency speculation, right? And you hear central banks will come out and say like, oh, stern words to the speculators, you better watch out and that sort of thing. With Japan, do we have indication of how much of this is actually speculation versus to your point earlier, like actual outward investment?

• 14:22Speaker 05

  Like, there's a bit of speculation around the yen.

• 14:27Speaker 05

  You know, there's not a clean measure of the speculative flow, but like, you know, look, the yen was

• 14:34Speaker 05

  the, one of the lowest yielding currencies, so you, it was a typical funding currency. I don't think the carry trade was on in a normal scale, but there were certainly hedge funds, others, who more or less thought that the Ministry of Finance was going to allow the yen to weaken beyond what it had weakened before. And since, you know, the yen, shorting the yen is positive carry. There's a higher yield on dollars than on, on yen. As long as you're, it's stable, you make a little bit of money and if the yen depreciates, you make a lot more money. So there was a bit of speculative betting on it, not a ton, I would say. And then you have weird hedging dynamics.

• 15:17Speaker 05

  So there's a little bit of a hed, dynamic where when the Nikkei goes up, foreigners holding the Nikkei need to hedge a bit more because some do partially hedge. When the Nasdaq goes up, the GPIF doesn't hedge, so it doesn't generate an offsetting hedging flow. And then despite all the Hedge America stories from last year, in Japan, the key fixed income hedged investors seem to have gone a little bit less hedged, the life or hedge ratio has come down. So you don't, so a lot of it is not quite your classic speculative flows, although there's a bit of that. A lot of this is hedging flows amongst real money investors. So that does add a little bit of a different dynamic. But I, I don't discount the fact that a bunch of

• 16:01Speaker 05

  investors, including a bunch of hedge funds, were basically making a bet that the yen would go to 170 because you waited was behind the curve.

• 16:09Joe Weisenthal?

  So let's talk about it from the US perspective. What is the reason that the weakening of the yen is something that would or should concern the Treasury Department?

• 16:23Speaker 05

  Well, I think the, the classic concern, which hasn't been the concern that Secretary Besen is articulated, is that extreme weakness in East Asian currencies gives East Asia a trade edge over American producers. I mean, classically, a weak yen is bad for Detroit, a weak Korean won is bad for Detroit. It's really, uh,

• 16:48Speaker 05

  you know, the traded goods pressure, most classically through the automotive sector, that has been the traditional driver of this. And to be clear, we are like 50, you know, the won's come back a bit, but 1500 is a crisis level of the won and Korea is not in a crisis. 160 is an insanely weak yen on any Big Mac index. It pushes the yen below in inflation adjusted terms where it was in the 1970s, we're back to the 1960s. These are extreme undervaluations, in my view. And so in that sense, the classic concern would be that this gives all these guys a huge edge over American manufacturers. That hasn't been what Besen has emphasized.

• 17:31Speaker 05

  He's emphasized, well, the weak yen is putting pressure on the won, is adding to this generalized malaise, bizarreness, where good news is bad news for a lot of Asian currencies. And then there's a sense that this could create pressure on the treasury market. Now, to be clear, if the yen just falls, that makes the value of Japanese investments in treasuries higher. So the, the impact on the treasury market would come if the Japanese resisted that, used their reserves and the excessive use of their reserves or the use of their reserves started to, to put pressure on the treasury market because they have to fund, they would fund it by selling treasuries.

• 18:15Speaker 05

  So I think part of Besen's theory of the case is that by joining with the Japanese, first of all, you know, we're, we're supporting the yen from an incredibly weak level, it's arguably overshot. It has decoupled from five-year, 10-year rate differentials for the past several months, past year even. And by helping the Japanese, we're helping a friend, that's what the president says. And we can jointly intervene in a way that reduces the possible pressure on the treasury market. That would be, I think, the explanation I would give, but I, you know, Besen hasn't been, he's more, I mean, the president said it was to help a friend.

• 18:55Speaker 05

  Besen has said it's to avoid destabilization throughout the Asia currency complex.

• 19:01Tracy Alloway?

  Why did they do it in euros? Or why did the US do it in euros? They sold euros.

• 19:07Speaker 05

  I mean, you know, some of it is just Secretary Besen being a former currency trader, wanting to have presumably a bit of fun. Um, you know,

• 19:15Tracy Alloway?

  Just getting creative.

• 19:15Speaker 05

  We have euros, we can use euros, we have a few more dollars, but only a few more dollars. I mean, you can debate, I mean, this was clearly an intervention. But you know, when you shift your, the composition of your reserves around, sometimes that's not even viewed as intervention because you're not selling your currency to buy another guy's currency. I think he presumably did it because he wanted to be a bit cute and say, well, this isn't, this is not a view about the dollar. We still want a strong dollar. This is just a view about the yen and we're just expressing this in a way that makes it clear that this is a view about the yen. It also let him do like kind of surprising things, like there was the rate check in euro yen, which caused a lot of confusion in the market.

• 20:00Speaker 05

  But at the end of the day, the, you know, we don't know the volume, we don't know if he actually did the five to 10. Maybe we'll see in a week or so. But the vast bulk of the intervention was from Japan's Ministry of Finance and it was in dollar yen. So fundamentally, this was a dollar yen intervention, not a euro yen intervention.

• 20:18Joe Weisenthal?

  Brad, you mentioned that if you were to go buy something like the Big Mac Index, the dollar yen or the yen is at historically weak levels. And of course, there's all kinds of attempts to measure like what like fair value of a currency is, right? So you mentioned the Big Mac Index and then there's like, I don't know, beer models and rear models and exchange rate differential models and GDP differential models. Do any of them work anymore? Are any of them consistently either predictive or useful? Or like, what is the state of all of these sort of classical approaches to determining fair value of any given currency?

• 21:02Speaker 05

  The Big Mac Index is a version of purchasing power parity. That sort of prices broadly speaking should be the same if you're at comparable levels of development. Recently, particularly vis a vis Asia, the market pressure, the financial pressures have pulled currencies further away from their purchasing power parity levels. So that hasn't, as a predictive variable, that hasn't worked. As an analytical tool, I still think it's valuable. You know, a behavioral equilibrium exchange rate model fundamentally looks at policy settings today and says, you know, what's the impact of the policy settings? And then it says, we don't know what the equilibrium value of the currency is,

• 21:46Speaker 05

  but we know what it is, where it has been in the past. So given the policies and given the past, is the currency strong or weak? All the Asian currencies kind of score as weak on this because they are fundamentally incredibly weak. I mean, we haven't talked about China, but China has a big and growing trade surplus. Use a current account based model, you'll find that China's currency is undervalued. Certainly Korea's currency is undervalued on a current account based model. All these show is undervalued on behavioral exchange rate based models. So basically, like what we know is that financial flows have pulled currencies quite far away from any of the more fundamental or purchasing power based measures.

• 22:29Tracy Alloway?

  So I want to go back to the idea of avoiding additional pressure on the US Treasury market. And a big component of this seems to be use of this Fed facility that I mentioned earlier. It's called the Foreign and International Monetary Authority's Repo Facility. Very catchy, or FEMA. And it basically allows foreign central banks to use their treasuries as collateral to get dollars. But from what I understand, and I should say, this facility, I think, came about during 2020, during the pandemic with the big Treasury market rout. From what I understand, it charges above market rates for central banks.

• 23:11Tracy Alloway?

  And so one of the criticisms I've seen lately, or maybe concerns, is that the FEMA repo facility is ultimately going to be uneconomical for central banks. Like, why would they want to use it if they could just repo treasuries at cheaper market rates? And then secondly, the facility is also capped at something like 60 billion. So if you need to intervene again, someone's going to have to raise that limit. What are the sort of pros and cons of using this particular facility in this way? You're a fan, right?

• 23:44Speaker 05

  I'm a fan. I publicly, I privately pushed for it back when I was at the Treasury. I publicly pushed for it in 2020. I think it is a useful tool. The basic idea is that central banks have a lot of really good collateral. And if they need cash, they don't actually have to go and sell the treasuries into the cash bond market. They can just, you know, repo them at the Fed, get dollars, and then intervene that way. And it's zero risk to the Fed. And the Fed can always offset any monetary impact with its domestic operations. So there's no necessary monetary impact. It's just a way to allow, in times of stress or times of pressure,

• 24:27Speaker 05

  a central bank to avoid having to immediately sell treasuries. And remember then, 2020, we had kind of got into a downward spiral in the Treasury market where central bank sales were sort of begetting, begatting private sales. And the long bonds was really selling off and the Fed had to come in and do a lot of direct bond purchases. So, you know, it sort of makes sense to have this additional tool in the toolkit. You know, why do it with the Fed rather than with a, well, first of all, I guess, you know, the Fed, not in this case, is a little quieter as a counterparty. I mean, it is disclosed, but with a weak lag.

• 25:07Speaker 05

  In theory, you know, if you get rid of the cap, it's unlimited in the quantities. And then the premium is there. It's not huge, but you know, you can debate where it is. It was not meant to be used as a, as a substitute for repo in ordinary conditions. So it has, does have a premium. I think you can argue that right now, if you're the Ministry of Finance and you got a legacy five-year bond with a pretty high coupon, you're better off using FEMA repo than dumping it in the market. You're going to be able to cover the cost of FEMA repo out of the coupon on the bond. And if, obviously, if you sell the bond, you're never going to get that bond at that yield back.

• 25:50Speaker 05

  It gives, you know, the Ministry of Finance a bit of flexibility. At a minimum, it means it can intervene and then sell treasuries with a lag. It doesn't have to sort of immediately sell. Now, Japan does have a cash buffer. When they've intervened in the past, for whatever reason, they haven't used their cash buffer. They've pretty directly sold treasuries. So I think, you know, it just gives another tool to the Ministry of Finance and gives the Ministry of Finance more options about how it generates the dollars that it's selling.

• 26:42Speaker 01

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• 28:48Joe Weisenthal?

  Is there anything stopping Secretary Besen from saying, you know what? $150, $150 end of the dollar, that is our line in the sand. We're not going to let it weaken beyond that. And then you might not even have to spend a penny because, you know, no one's going to, people might not want to test it. And you just say, we have unlimited, unlimited firepower because we're spending our own currency. We're just going to cap it there.

• 29:13Speaker 05

  Yeah, there is something that limits Secretary Besen from doing that, which is that he doesn't control the Fed's balance sheet.

• 29:18Joe Weisenthal?

  Okay.

• 29:19Speaker 05

  Secretary Besen just has the ESF. Now, the ESF has ballpark 20 billion in FX, ballpark 20 billion in like liquid dollar cash, and then the special drawing rights, which it has like 160, 170 billion of a lot, but not unlimited. And using the special drawing rights is kind of even more out there than using FEMA repo. You know, it's sort of, so, you know, the Treasury on its own probably doesn't have the firepower. Now, you can argue that between the Treasury, the MoF, if Japan could, through some magic, change some of the pension funds, operating guidance,

• 30:02Speaker 05

  so that it started hedging its $950 billion portfolio, there's more than enough firepower there collectively to set a target, sort of a yield curve control type target, 150, probably be more like 160 now, and thereby implement that. So, you know, whatever it takes, this is going to stay below 150 or 160. The world does change. Oil shocks happen, inflation shocks, the Fed may be raising rates. People think the Bank of Japan is likely now to raise rates. So I think the risk on that is that you get locked into defending a level and then the world changes. But, you know, conceptually, you could try to do that.

• 30:44Speaker 05

  I think what the Ministry of Finance is trying to do is reestablish fear in the market around 160.

• 30:50Joe Weisenthal?

  Okay.

• 30:50Speaker 05

  I mean, that used to be kind of a level where, you know, if you were going to go short the yen, you'd be a little nervous that the MoF might come in and whack you. But then when they didn't defend 160.

• 31:02Tracy Alloway?

  It's like the mafia whacking you, right?

• 31:04Speaker 05

  Look, the weak side of, of the yen has been defined by the Ministry of Finance for the past several years. I mean, that's, that's a conventional view in the market. Given that the interest rate differential favors the dollar. By the way, we should discuss fiscal policy because US fiscal policy is way worse than Japanese fiscal policy. So I don't buy this fiscal fears or whatever. It is rate differentials. But the rate differential has favored the dollar and the, the limit. For the past, I would say, three years on how weak the yen gets is has been set by the MoF. And when the MoF didn't intervene at 160, and then the last time it intervened at 162, you know, people thought, well, maybe they're going to allow further moves and we'll, we'll

• 31:48Speaker 05

  make a bet that the MoF is going to tolerate a weaker yen, given that you wait has been slow to raise rates. And so I think this is fundamentally about saying, we're going to defend 160. There's a lot of risk around 160. Be careful if you want to just go short yen when you're close to that level, which is a softer version of the, we're just going to defend 150 to kingdom come.

• 32:13Tracy Alloway?

  All right. Well, on that note, perhaps the biggest question other than, you know, why did all of this happen is, is it going to work? And I mentioned earlier, the yen is trading at like 155, 156 to the dollar. That's better than where it was before this intervention, but it is starting to weaken ever so slightly again. And on that note, Adam Posen had a pretty funny quote in the Financial Times. Did you see this joke?

• 32:42Speaker 05

  Oh, I didn't see it, no.

• 32:43Tracy Alloway?

  So basically saying, verbatim quote, "The irony of the guy working for Soros and Stanley Druckenmiller, who broke the Bank of England back in 92, pretending that you can do FX intervention alone and lastingly defend a currency is just amazing." So again, this idea of like, how much firepower does the US actually have? Does this need to be more coordinated? Do you think this is enough?

• 33:07Speaker 05

  I think it will be enough if the Bank of Japan is gonna raise rates and maybe raise rates several times. I think the only reason why it wouldn't be enough if the Bank of Japan is going to raise rates. And look, I think if the Bank of Japan doesn't raise rates in September, this will be tested, clearly. I mean, that's, that would signal there's not full commitment inside Japan to defending the currency, even in the classic sense, the monetary and fiscal authorities have different views. But if the Bank of Japan does raise rates, the other side of the, the currency pair is the dollar, and so it depends a little bit on what worst does.

• 33:51Speaker 05

  But if the Bank of Japan is raising rates faster than the Fed from this point on, I actually do think this will work. You know, there's, Adam never believes currency intervention works, by the way. So it's not at all a surprise that he has this view. And I, I think he should reflect a little bit on why the yen and why currency traders are nervous around key levels, because in the short run, most market people I talk to say intervention can work in a, over a reasonably short period of time. And it can work over a longer period of time if the currency is overshot. I would say the yen has overshot. If the fundamentals are evolving in a way that is going to be eventually favorable to

• 34:33Speaker 05

  that currency, you can make that argument with Japan. You know, oil prices, if, you know, that depends on what happens in the straight and with Iran, but oil prices are not at their highs. That helps Japan. The BOJ seems likely to raise rates in September. Certainly, the BOJ could be on a path that brings short-term rates up to closer to, you know, inflation, so on a path that leads it to two over time. That should support the yen if the Fed's stable. Long-term Japanese rates have converged with long-term US rates. So the, the long-run interest rate differential is now at, actually at odds with the yen. It's, given this rate differential, the yen should be stronger.

• 35:18Speaker 05

  The current account is actually quite solid, 5% of GDP. Japan's getting ever more money on the same level of its US portfolio because US rates are now higher than they were when Japan bought its original bonds. So that's not really at risk. And, you know, the key thing is that you gotta change expectations, and the expectations have been that the yen's gonna stay weak and maybe get weaker. So in that context, this huge foreign portfolio of Japanese institutional investors is generally becoming less hedged over time. You change that, and I think you change the dynamics. And where I probably differ a bit from people like Adam or more like the conventional international

• 36:00Speaker 05

  macroeconomics school is that, you know, I do think Japan is unique in a couple of ways. One way it has been unique is that, you know, the, the companies that have this massive foreign presence make enormous profits abroad. Those profits translate into enormous yen profits, but they don't actually bring the dollars, euros, yuan that they earn abroad back home. They tend to reinvest it. So that doesn't generate a flow. And then the irony is a lot of the non-FDI foreign assets are held by the government. You know, the bulk of the unhedged, unhedged portfolio is actually in the hands of the MoF and the GPIF, the pension fund. And they typically don't repatriate.

• 36:44Speaker 05

  So you, you know, they're generating, you know, the, the reserves were generating 35 to 40 billion in interest a year, but in normal times, that just was compounding abroad. The GPIF gets dividends, it gets interest, it doesn't repatriate that. Now, there's some portfolio rebalancing, there's some additional complexities, I won't go into that. But in the normal course of action, all this interest income that goes to the government, which is well above a, you know, it's well above a percentage point of GDP, it's heading towards two percentage points of GDP, doesn't hit the FX market. So in a sense, I think you need, in order to equilibrate flows, you're gonna need to

• 37:24Speaker 05

  see a way to, you know, have the winner of a weekend, which in a financial sense, has been the government of Japan. Take some of its winnings and bring them back home. And so in that sense, I tend to view this a little more favorably. I think this is part of the conditions needed to set a floor under the yen over time, together with the Bank of Japan. So to me, you gotta have the Bank of Japan, and then you have to have the flow dynamics. And the interesting thing about Japan is that the government is by far the biggest actor on the flow dynamics. It has the biggest foreign asset position, and it has the biggest capital gains from yen weakness.

• 38:03Joe Weisenthal?

  By the way, for those who don't know the numbers, you know, as you mentioned, the long end of the curves in the US and Japan converged somewhat, but you know, the Fed's current rates is between three and a half and three and a quarter. Bank of Japan is still at 1%. So that's really where this gap persists. We'll see, as you mentioned, if the BOJ closes it. Before we wrap, let's talk about fiscal policy for a moment, because, you know, going back at 2016, the yield on the Japanese 30-year was like 0.05, like something, like truly nothing, and now it's like around 4%. There are these, because the debt to GDP is so high, there are these fears that if rates

• 38:44Joe Weisenthal?

  rise across the curve, a significant share of government expenditures are in the form of interest payments that furthers the inflation problem than you have when people call fiscal dominance, it spirals out of control, the central bank can't fix it. That is sort of like the classical version of why some people think that you should short the yen because it will one day be worth confetti, or something like that. What is wrong with the theory that this is the, the piper being paid? Is that a phrase, the piper being paid from years of overly loose fiscal policy?

• 39:15Speaker 05

  Well, I like, I like the way you phrase it as years of overly loose fiscal policy, because you didn't say today's fiscal policy is overly loose.

• 39:24Joe Weisenthal?

  Right.

• 39:25Speaker 05

  What has changed, certainly compared to 2014, even compared to 2016, is that the primary balance, so excluding interest, government revenues relative to expenditure, has, is now in balance, it's now flat, there's no primary deficit. That makes Japan one of the better G7 economies, certainly better than the United States, certainly better than UK, certainly better than France. I think better than Germany now, too. I mean, I think if you count the defense spending. So Japan no longer has a big primary deficit. It's primary, is actually trending towards a primary surplus. The MoF loves to play games where if you don't do a stimulus, you actually tighten,

• 40:09Speaker 05

  because the way they structure the budget, they sort of force the government to go out and argue for a stimulus to offset what they mechanically have baked in as a tightening, which is why we ended up, you know, Japan has outperformed the IMF's forecast this year. It's really, you know, at, at a primary balance rather than in a modest 1% primary deficit. And so, you know, you, you're not in a position where things are on the edge of spiraling out of control. Now, it is certainly true that the interest burden will go up if the Bank of Japan hikes rates, and it will actually go up even if the Bank of Japan doesn't hike rates, because there's an awful lot of bonds that were issued in the past at very, very low rates.

• 40:54Speaker 05

  They will mature, they'll have to be refinanced. With higher inflation, higher nominal growth, the debt dynamics don't go crazy, because you have higher nominal rates, but your nominal rates aren't wildly out of line with nominal growth, real rates are probably still below or equal to real growth, and your primary's in an okay position. The other weird thing about Japan is that the government of Japan holds on its balance sheet. So the Ministry of Finance is part of the government, it holds the reserves. The reserves in Japan make money. They are in dollars with this higher interest rate compared to the short-term cost of funding in yen.

• 41:35Speaker 05

  The GPIF, the government pension fund, makes money, it has higher yielding foreign assets. So the net interest payments on Japan are actually, for at times, they've been close to zero. Now, that's, you know, a function in part of the backward-looking low rates, but it's also a function of the fact that Japan's government has this massive foreign asset position. Long-winded way of saying, there is, you should worry if nominal rates go way up and inflation doesn't go up. But if nominal rates converge to levels that are consistent with inflation,

• 42:17Speaker 05

  and if the primary stays where it is, Japan's debt dynamics are actually not bad. The net debt levels have been falling. In five years, without much change, net debt in the US will surpass or be close to that of Japan. And remember, when you're short in the yen to go long the dollar, you're going long US fiscal. And I would argue, if you look at the full range of variables, not gross debt, but the dynamic path of net debt, the primary, absolutely, the fiscal balance, 1% of GDP in last year, and that's not the US, we're at six, we were five-ish last year, but we're now at six, we're heading up. That's before the defense spending. I think what has gotten people nervous is Takeichii doesn't want, at a minimum, to get a bigger surplus.

• 43:02Speaker 05

  She's pushing back against the MOF's plans. She may want to go back to a modest primary, and she expresses this in a way that generates a lot of angst. But the underlying fiscal performance of Japan, stack up Japan using the IMF's fiscal monitor variables against the US, and then compare that to the rhetoric that is tossed around, and I would say there's a very big gap.

• 43:29Tracy Alloway?

  All right, well, on that note, Brad, thank you so much for coming back on the show. Really appreciate it.

• 43:35Speaker 05

  Oh, thanks. Thanks for letting me explain my, uh, this is one area where I'm not the most conventional.

• 43:40Joe Weisenthal?

  Yeah, that was great. That was excellent.

• 43:42Speaker 05

  And just remember, this last thing, just always remember, Japan is selling dollars it bought between 80 and 100, depending on when they bought them, and somewhere around 160. This, at the worst, you can say, this operation, it reduces gross debt in a really big way.

• 44:04Joe Weisenthal?

  That was excellent.

• 44:05Tracy Alloway?

  Thanks, Brad.

• 44:06Joe Weisenthal?

  Hopefully, talk to you soon, but not too soon.

• 44:21Tracy Alloway?

  Joe, always good to catch up with Brad and get his perspective.

• 44:24Joe Weisenthal?

  Yeah.

• 44:26Tracy Alloway?

  A few things stood out from that conversation. So, one, it is kind of crazy how long the memory of the lost decade is lingering here. And we see this time and time again, both in economics and the business world, which is like, people just remember the past cycle, right? And it influences their current behavior. Understandably so in the case of Japan. The other thing that stood out to me is this idea of, okay, the Treasury has done this sort of creative intervention in order to ease pressure on long-term Treasuries. But there seems to be a tension there with what the Fed's doing at the moment, right? So, WASH is like, oh, you know, like, markets, you have more of an activist say in where Treasury yields are going.

• 45:10Tracy Alloway?

  It shouldn't all be about the central bank. And so, we've seen longer-term Treasury yields go up. So, now you have this weird situation where, like, Treasury clearly wants them to come down, whereas the Fed is kind of like, do your own thing.

• 45:24Joe Weisenthal?

  Totally. There's lots of in there. One of the first things that Brad said that I thought was interesting, and it sort of, and it speaks to your point about the lost decade, is he's like, oh, the BOJ has done all this work to get inflation back to 2%. And in my mind, I was thinking like, oh, yeah, right? Like, they must, when he says, all this work, they're trying to get inflation back down. But then I remember that in Japan, it's the other direction. And so, like, you know, for years, the story was like, no inflation, no inflation. Maybe they just want to let it run hot a little while to fully put the lost, really multiple decades of like, no inflation, truly in the past. I also think it is interesting, and probably, and no one really talks about it, the idea that Japan's fiscal position, at least by certain objective measures,

• 46:08Joe Weisenthal?

  clearly improving, clearly looking better than the trajectory of the US these days, at least if you're looking at a primary deficit. And then, to his point, you know, there's numerous, you know, the classical metrics that economists use to measure the valuation of a currency. We know none of them are that great as metrics go, but they all point to the end, in fact, being undervalued.

• 46:29Tracy Alloway?

  Yeah. All right. I think we should end it there before I make a terrible turning Japanese Treasury market cliche.

• 46:37Joe Weisenthal?

  Oh, you know what? I thought of a good pun, but someone had already used it.

• 46:41Tracy Alloway?

  Oh, what was it?

• 46:42Joe Weisenthal?

  Keep calm and carry on, but, uh...

• 46:45Tracy Alloway?

  Yeah, all right.

• 46:46Joe Weisenthal?

  No, you know, it's like, it's actually been used a handful of times. And, uh, yeah, I just looked it up. It's just a few random, um...

• 46:52Tracy Alloway?

  You need to make those posters, stick them on the wall.

• 46:55Joe Weisenthal?

  Yeah. If I had been the first, I would do it, but I was not.

• 46:58Tracy Alloway?

  All right. Shall we leave it there?

• 46:59Joe Weisenthal?

  Let's leave it there.

• 47:00Tracy Alloway?

  This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 47:05Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at TheStalwart. Follow our producers, Carmen Rodriguez at CarmenArmand, Dashal Bennett at Dashbot, Kell Brooks at KellBrooks, and Kevin Lozano at KevinLloydLozano. And for more Odd Lots content, go to Bloomberg.com/oddlots, or have a daily newsletter on all of our episodes. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

• 47:29Tracy Alloway?

  And if you enjoy Odd Lots, if you like it when we shine the Brad Setser bat signal, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

• 47:49Speaker 07

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• 48:20Speaker 08

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