Yen Temporarily Stabilized, But Real Stress Test Comes After Midterm Elections

Following coordinated intervention by the US and Japan in the foreign exchange market, the yen has temporarily stabilized after a sharp decline. However, the underlying purpose of this rescue operation may extend beyond mere exchange rate stabilization.

Ed Dowd, former Wall Street fund manager and macro analyst, argues that the timing of this intervention closely aligns with the US midterm elections. One key consideration, he suggests, is to prevent Japan from being forced to sell over $1 trillion in US Treasury bonds due to persistent yen depreciation, which could push up Treasury yields and trigger financial and economic turmoil during a politically sensitive period.

The problem is that structural issues such as the interest rate differential between the US and Japan remain unresolved. Once the midterm elections conclude and political motivations for market support fade, the market will closely watch whether the yen can maintain its current level.

Short-Term Success, Long-Term Effectiveness in Doubt

The joint intervention has already had a swift impact on currency markets. The yen rebounded from a low of 163.65 to around 159.09, marking its largest weekly gain since February. US Treasury Secretary Scott Bessent confirmed the coordinated action on August 2 and stated that the US would not hesitate to participate in further joint interventions.

Nevertheless, market participants widely believe that foreign exchange intervention alone is merely a temporary fix. Historical experience shows that without supportive fundamental policies, intervention effects are often short-lived. As interventions become more frequent, the required scale increases while marginal effectiveness diminishes.

Dowd warns that without sustained policy follow-up from Japan, the yen may eventually weaken again, forcing authorities to conduct larger and more frequent interventions—each round increasing the risk of sharp asset price volatility and liquidity events.

Behind the Yen Rescue: Preventing US Treasury Sell-Off

To understand the deeper logic of this intervention, the key lies in Japan's massive holdings of US Treasury bonds. Japan is one of the largest foreign holders of US debt, with holdings exceeding $1 trillion. When the yen depreciates sharply, Japanese authorities may face pressure to defend the currency by using foreign exchange reserves and selling US Treasuries, directly pushing up Treasury yields.

With the US running persistently high fiscal deficits, a rapid rise in Treasury yields could lead to more severe consequences. From this perspective, the immediate trigger for the intervention may have been the risk of US Treasury sell-offs due to yen depreciation, rather than simply defending the yen.

Bessent also cited lessons from the Asian financial crisis, noting that an extremely weak yen could create spillover effects, making preemptive action preferable to waiting for a crisis.

According to Reuters, the US Treasury Department notified several banks via the New York Federal Reserve ahead of the intervention, urging them to prepare for follow-up actions—highlighting the high level of coordination involved.

FIMA Expansion Eases Pressure on US Treasuries

Another critical aspect of this action is Bessent's explicit support for expanding the FIMA (Foreign and International Monetary Authorities) repo facility.

This mechanism allows foreign central banks like Japan's to use their US Treasury holdings as collateral to obtain dollar liquidity from the Federal Reserve, without having to sell Treasuries directly into the open market.

Analysts believe this arrangement effectively exchanges Treasuries for dollars, reducing selling pressure in the market and further curbing upward pressure on yields.

Yen: Not Too Weak, Not Too Strong

The intervention also brings another risk—the massive scale of yen carry trades.

For years, the low-interest-rate yen has been widely used as a funding currency, with investors borrowing yen to invest in higher-yielding currencies and assets. If the yen appreciates rapidly, financing costs rise, potentially forcing large-scale unwinding of carry positions, which could shock global equities, bonds, and other risk assets.

August 2024 serves as a recent example: the yen appreciated about 10% in a short period, triggering severe volatility in Japanese and global risk assets.

This intervention has driven the yen up about 5%, and market reactions have remained relatively calm so far. However, risks remain in the outlook.

This puts US and Japanese authorities in a dilemma: they cannot allow the yen to keep depreciating and force Japan to sell Treasuries, nor can they let the yen appreciate too quickly and trigger a cascade of carry trade liquidations.

After the Midterms: The Real Test Begins

A bigger issue is that this intervention has not resolved the structural factors behind the yen's weakness. Japan's prolonged ultra-loose monetary policy creates a clear interest rate differential with the Federal Reserve, which continues to weigh heavily on the yen.

At the same time, Japan's public debt-to-GDP ratio is among the highest globally, limiting fiscal space and constraining the Bank of Japan's ability to normalize policy. If the BOJ cannot sustain rate hikes and fiscal discipline does not improve, the yen may face renewed depreciation pressure.

The real variable may emerge after the US midterm elections. If this intervention was indeed politically motivated to maintain market stability before the election, the question will be whether the political will for US-Japan joint market support persists afterward.

At that point, if Japan's structural issues remain unresolved and the effects of this intervention fade, the market could face even greater pressure than it does today.

In other words, the yen may only be temporarily stabilized—the real stress test likely awaits after the midterm elections.