Japanese authorities are back to warning markets about the exchange rate once again. The yen once again weakened to a 38-year low against the dollar. Once again the market is talking about intervention. It seems like a never-ending cycle.
The currency pair broke above the crucial level set back in April when the BOJ intervention aimed to cut the market’s wings. Several rounds of interventions lead to almost a thousand pips being retraced over the course of a week. But the market just pushed it all back over the next couple of months. And we are in the same place as before, largely because the market believes that Japanese authorities are trapped.
Repetition or Rhyming History?
To understand why the market is not only refusing to be cowed by financial authorities, but actually challenging the powers in Tokyo, we have to step back a bit. The main thrust of USDJPY over the last couple of years has been carry trading. As the Fed raised rates, but the BOJ did not, the interest rate gap between the two economies made it profitable to sell yen in order to buy dollars.
Momentary fluctuations in relative interest rates are normal, and the market usually adjusts. In fact, this is one of the main drivers of price action. The problem with the yen in particular is that the BOJ was in an easing stance while the rest of the world was hiking. That made it a particular target for carry trading. Normally, a central bank would adjust its interest rate in line with other currencies in order to avoid excessive swings in the exchange rate, since that ultimately affects price stability.
Caught in the Liquidity Trap
Markets have been repeatedly testing Japanese financial authorities to see what they would do. And so far, the interventions notwithstanding, the response has been underwhelming. With the underlying problem being a difference in interest rates, the “fix” is to balance those rates out. Earlier in the year, it was expected the Fed would cut rates as much as six times this year, which would narrow the interest rate gap substantially.
But high inflation in America has put off those rate cuts, to the point that the Fed is only predicting one cut this year. The BOJ, on the other hand, can’t raise rates too fast without triggering its own (and possibly much worse) version of the 2023 financial banking crisis in the US. Markets had been initially hesitant about driving the yen too low, because that could prompt a serious response from the BOJ: Raising rates. But the hesitancy around tightening monetary policy likely has convinced many traders that Japanese authorities are not capable of fighting off the market.
So, Now What?
The markets took the last BOJ intervention seriously, because it could have been a precursor to other measures that financial authorities could take. But even the softest measures – such as merely saying that the BOJ wouldn’t be buying unlimited amounts of bonds to keep the interest rate lower – were not taken up. This suggests that if the BOJ intervenes again, it might have even less credibility than last time.
By letting the currency go above the level at which they intervened last time, Japanese authorities are essentially communicating there is no “red line”. That is, they are accepting the progressively weaker yen. And the market is now seeing just how fast it can drive up the USDJPY, not whether or not the BOJ can stop it.
