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CONTRIBUTORS

Robert O. Abad

Western Asset

Beginning on July 31, the US Treasury participated in coordinated foreign-exchange intervention with Japan to strengthen the yen, the first such joint effort since 1998. The intervention generated considerable attention, including speculation that US involvement could also help contain upward pressure on long-term US Treasury (USTs) yields. The yen initially responded sharply, but much of that move has since reversed. What does this mean for markets beyond currencies?

Exhibit 1: Spot the Intervention—Effects of US/Japanese Yen Purchases Already Wearing Off

Source: Bloomberg. As of 11 Aug 26.

For years, an unusually persistent gap between Japanese interest rates and those available elsewhere has made the yen one of the world’s most important funding currencies. Over much of the past decade, the Bank of Japan (BoJ) kept short-term rates close to zero while large-scale Japanese government bond (JGB) purchases and yield curve control measures held down longer-term yields. As rates rose elsewhere, particularly in the US, Japanese investors recognized that persistently low domestic yields made investing outside Japan increasingly attractive.

Japanese insurers, pension funds, banks and asset managers accumulated substantial foreign assets, while the yen’s exceptionally low funding cost made it an important financing currency for investors globally. A weaker yen further supported the economics of those positions, especially for Japanese investors holding unhedged foreign assets.

That relationship is now changing. Japanese government bond yields have risen as the BoJ moves away from the policies that kept yields anchored for so long, making domestic bonds an increasingly credible alternative for Japanese investors.

The experience of August 2024 provides a useful reminder of why shifts in this dynamic can matter beyond Japan. A BoJ rate increase coincided with growing expectations for lower US rates and deteriorating global risk sentiment, putting pressure on leveraged positions funded in yen. As those positions were reduced, risky assets sold off and the yen strengthened, creating a self-reinforcing cycle of deleveraging and market volatility. The episode showed how quickly crowded yen-funded positions can amplify market moves.

None of this suggests that another disorderly unwind is approaching. The more relevant question is how rising Japanese yields might change the investment decisions of Japanese institutions. Some may already find current JGB yields attractive enough to add domestic exposure, while others may require higher yields depending on their liabilities, hedging costs and existing portfolios. In effect, each investor has its own “zone of interest,” shaped by the particular investment problem it is trying to solve.

This matters globally because those decisions don’t take place in isolation. As Japanese yields become attractive to a broader range of domestic investors, USTs, European government bonds and other overseas markets must compete against a more viable domestic alternative.

The impact doesn’t require Japanese investors to become large sellers of foreign bonds or trigger a repeat of August 2024. It could simply mean less incremental buying as more capital stays at home or as Japanese investors wait for better opportunities overseas. Even without a dramatic shift in existing holdings, that change in marginal demand could influence how global bond markets reprice.

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