The U.S. Treasury’s decision to partner with Japan in propping up the Yen is a reminder of the risks created when governments spend years suppressing bond yields. Bonds provide the foundation of risk for the entire financial system, which is why excessive intervention in fixed-income markets is particularly worrisome. Government bonds from well-rated countries are considered the risk-free asset that determines how asset prices are valued and the cost of capital. Sovereign debt underpins the financial system and serves as the foundation for risky asset markets.
Bond yields are never true market prices. Government interference is a fact of life. Governments issue bonds, and selling and buying them is how they conduct monetary policy. But intervention has its limits. Markets still play an important role, especially in long-term bonds, and too much interference distorts how capital is allocated and leads to pricing risk. Even worse, it enables fiscal recklessness. When it goes badly, things turn pear-shaped quickly and can lead, and have led, to global financial crises. Yet interference is the norm because governments prefer to choose the price at which they borrow rather than let the market decide. Sometimes they can pull it off, even for decades, but eventually a reckoning comes. Japan is a telling case in point.
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For decades, Japan did everything it could to keep the yields on its bonds low by buying its own debt or enacting regulations so that pension funds or other entities would buy the debt. This enabled it to keep borrowing despite fairly anemic growth. Japan became the poster child for why debt doesn’t matter and the idea that countries could spend as much as they wanted without increasing interest rates. Japanese interest rates were less about the market’s valuation of its debt than about Tokyo’s attempts to keep yields low by purchasing bonds or encouraging savers to do so. This repression enabled higher debt loads, though the mispricing of risk was not without costs. It depressed growth by distorting capital and talent, and generations of Japanese savers never saw much return. It also created the Japanese carry trade, where investors would borrow at low rates in Yen and then invest in higher-yielding assets somewhere else. The carry trade ensured a healthy demand for the Yen.
But yield-curve repression stopped working once Japan had to contend with inflation, and keeping rates low put more upward pressure on prices. The Bank of Japan had to let rates increase. It attempted to do so in the most controlled, glacial way possible, but it wasn’t credible. Japan intends to spend more to counteract low growth, which is putting further upward pressure on rates. The carry trade has been on the verge of unraveling all year because rates seem set to increase, and that means a depreciating Yen, which could further destabilize markets.
Japan is trying to defend its currency, but that involves buying fewer U.S. Treasuries or selling the ones it has to raise money. America keeps its rates low by depending on foreign buyers, like Japan, which is why the U.S. Treasury stepped in to support the Yen in the first joint effort since 2011. So far, it seems to have worked.
But this is akin to putting your finger in a leaky dike. Treasury Secretary Scott Bessent believes the Yen was undervalued before the intervention, and that the move stabilized the market. But Treasury didn’t change the underlying fundamentals. First, as Robin Brooks points out, the U.S. sold Euros to buy Yen, which may undermine the effort to calm markets because needing to sell Euros raises questions about the Treasury’s cash flow. Also, the Yen is under pressure because Japanese yields are still much lower than they should be given inflation and the rising debt burden. These temporary measures don’t fix that. This is Tokyo’s third intervention this year, and the markets keep coming for the Yen because yields remain too low relative to other countries, let alone to the Japanese economic outlook.
This shows why yield-curve repression to finance endless spending doesn’t work, even in Japan. It may continue for decades if the financial conditions are right. But now Japan is stuck with high debt, low growth, and rising rates as inflation returns. The government can only distort the price of risk for so long. Eventually, fiscal reality comes home to roost.