Japan’s recent intervention in the currency market by buying yen may not have caused significant ripples in the U.S. bond market yet. However, experts warn that if Tokyo continues to engage in a prolonged battle to prevent the exchange rate from further depreciation, it could lead to a disturbance in the bond market. Central banks typically intervene in the currency market to prevent their currencies from depreciating too rapidly by selling dollar-denominated assets from their international reserves and using the proceeds to purchase their own currency.
It is believed that the Bank of Japan buys yen on behalf of the Ministry of Finance using dollar deposits held by the BOJ. These deposits are replenished by the sale of very short-term U.S. Treasuries or bills. This strategy minimizes the impact on the U.S. bond market, as selling short-dated notes, particularly bills, is more easily absorbed. It leaves the longer end of the curve untouched, which is more susceptible to pockets of illiquidity. Japan has a substantial pool of dollar deposits, estimated to be around $155 billion, but it is not infinite. If these reserves are depleted, there is a possibility that Japan, the largest foreign holder of U.S. Treasuries, might resort to selling U.S. bonds.
Japan reportedly spent about $35 billion on purchasing yen on a single day, with additional funds being used in September and October 2022. While sales of U.S. bonds are a possible option, Tokyo is likely to explore other avenues to support the yen before considering this step. Possible alternatives include encouraging repatriation, implementing tighter monetary policies, utilizing currency swap lines with the Federal Reserve, or accessing funds from other sources. However, the scenario of Japan engaging in a prolonged conflict with the foreign exchange markets remains a tail risk.
The Evolution of Japan’s Footprint
Japan holds a significant amount of U.S. Treasury securities, with figures showing $1.17 trillion in holdings as of February. However, the country’s presence in the U.S. bond market has significantly diminished over the years. In 2004, Japan owned 18.2% of all Treasury securities, a figure that has now dropped to just 4%. This decline is part of a broader trend where foreign central banks’ share of outstanding Treasuries has shrunk from 40% in June 2008 to 14% currently. As foreign official holdings of U.S. Treasury bonds have decreased, the foreign private sector’s share has grown, reaching around 17%.
The shift from foreign central banks to price-sensitive investors in the private sector could pose challenges for Treasuries in the future. With foreign central banks unlikely to expand their FX reserves, there is a risk that emerging market central banks may need to sell Treasuries to defend their currencies from significant weakening. While Japan’s recent intervention may seem relatively small in the context of the overall Treasury market, continued interventions or similar actions by other major holders like China could have a more substantial impact.
The recent currency intervention by Japan raises concerns about the potential impact on the U.S. bond market. While the initial effects may be limited, prolonged interventions or significant actions by major holders of U.S. Treasuries could disrupt the market. Bond investors will closely monitor the situation to assess any developments that may affect yields and overall market stability.