At the end of July and the beginning of August, Japan and the U.S. conducted a rare, joint currency intervention to support the yen, spending around $89 billion and $5-$10 billion, respectively. Initially, the yen strengthened from 164 to 156 against the dollar, but two weeks later, USD/JPY is back near 160. Why?
Because it did nothing to fix the underlying problems, including the huge rate gap between the U.S. and Japan, which keeps the carry trade attractive as investors borrow yen to buy, for example, higher-yielding U.S.assets.
But hasn’t U.S. inflation started to cool, so the Fed might turn more dovish?
Indeed, July CPI eased to 3.4% year over year from 3.5% in June. Core CPI fell to 2.5% from 2.6%. PPI also came in below expectations, flat month over month versus +0.2% expected, while annual growth dropped to 4.7% from 5.5%.
The problem is that oil prices remain elevated: gasoline is still above $4 a gallon, up more than 30% since the U.S. and Israel launched the war, raising the risk of another inflation wave.
Also, trade wars are back, with the U.S. set to impose 50% tariffs on some Canadian goods on Wednesday. Commercial ties with India and China could also worsen if Washington introduces tougher sanctions on Iran’s trading partners.
Thus, the Fed still has plenty of reasons to stay hawkish, even as markets bet on a softer path, with the probability of no policy change this year around 55%.
What if the Fed raises rates?
The Bank of Japan may have no choice but to tighten as well. As for the chances of the BOJ doing so without the Fed, this week’s July inflation data will be crucial, with strong numbers potentially pushing JGB yields higher and giving the yen some support.
Now, if even tighter monetary policy fails to stop the yen’s slide, which is already hurting households as Japan relies heavily on imported energy, the BOJ could be forced to sell Treasuries to raise cash and support the currency.
And markets seem to be pricing in this risk, with the U.S. 30-year Treasury yield hitting 5.216% at auction, its highest since 2001.
The takeaway is that if Japan starts selling U.S. Treasuries, market volatility could rise sharply, something most investors don’t expect yet.
This article was written by IL Contributors at investinglive.com.