Remember when Japan intervened in currency markets to save the yen a few weeks ago?
Apparently, the yen doesn’t remember. The Japanese currency is back to pre-intervention levels, creating very serious problem for an economy that relies on imported oil.
In late April, traders began to speculate that Japan was on a yen-buying campaign to stabilize prices. Evidence for this was a spike in the yen relative to the U.S. dollar. Now that time has run its course, it seems that this move did absolutely nothing to stabilize the yen. So, what comes next?
Should financial authorities let the yen fall further or should they try again to reverse the trend? It’s a nasty decision tree to think through. Let’s say Japan decides not to intervene again, and the yen weakens further. That would send a message to currency short sellers that they can keep pressing the value of the yen lower, all while Japan’s imports of oil skyrocket. Since oil is highly correlated to inflation expectations in a domestic economy, that would cause a potential collapse in Japanese bond prices and surge in yields. Good luck with that scenario given how much debt the Japanese government has. You’d blow out the deficit in that case.
The second scenario is that Japan intervenes again but far more forcefully. What then happens? Well, there’s only two ways Japan can support the yen. The first is by raising rates. The second would be for Japan to sell dollars to buy yen. If Japan were to pursue this scenario and not have enough dollars, financial authorities could sell Treasurys to raise cash.
That would put pressure on U.S. Treasurys, cause yields to rise, and potentially spark the reverse carry trade scenario I’ve brought up since August 2023. If that happens, anyone short selling the yen would be toast.
So how does this play out? I still think Japan will have no choice but to panic, and that we are in a slow-moving currency crisis that can unfold in erratic ways. Just because the stock market is higher doesn’t mean the risk of currency volatility has gone away. If anything, I’d argue it’s even more accentuated now. The stakes are higher given the prior failed intervention to reverse the yen. And if I’m right, then this should make for an interesting summer where things go haywire. This may be the precise reason why defensive sectors are leading the market beneath the surface.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
