Transcription
Welcome back everyone. Thank you so much for joining me. Thank you for being here.
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I know many of you are interested in how Japan's changing economic conditions will affect global financial markets, including the US economy. For many decades, the Japanese yen was considered one of the world's safest currencies. During every major financial crisis, investors typically rushed into the yen as a safe haven asset. Well, today that reputation is being tested, and some would argue that it is falling apart.
The Japanese yen has fallen to its weakest level against the US dollar in nearly 40 years. It trades around 163 yen per dollar. While this may sound as a problem that is unique to Japan, the implications extend far beyond its borders. Japan is not only one of America's closest allies in Asia, and some would argue that Japan is practically occupied, that it's not a sovereign state, and perhaps that is something that I can discuss with an expert. Let me know if you're interested in this topic, but for purposes of this video, we'll focus on economics.
So, Japan is of course the largest foreign holder of US Treasury securities. If Tokyo is forced to defend its currency more aggressively as it continues to weaken, it may have to sell a portion of those Treasury holdings, meaning that a currency crisis in Japan could quickly evolve into a problem for the United States.
The primary reason behind the yen's dramatic weakness is the widening gap between US and Japanese interest rates. For many years, Japan maintained interest rates near zero, while the United States Federal Reserve aggressively raised rates to combat inflation. Well, Japan didn't have that issue, so it kept its interest rates very, very low. That created one of the most attractive opportunities in the global finance. Investors could borrow money cheaply in Japan, convert those yen into US dollars, and then invest in higher yielding American assets such as US Treasury bonds. The strategy, which is known as the yen carry trade, has become one of the largest sources of liquidity in global financial markets. As long as US interest rates remain substantially higher than those in Japan, investors continue selling yen to purchase dollars, placing constant downward pressure on Japan's currency.
Interest rate differentials are only part of the story. Japan has also been burdened by soaring import costs, particularly for energy. Higher global prices for oil and natural gas have forced Japanese companies to spend significantly more dollars to purchase fuel from overseas. They have to import fuel, so really there's no way around it. Every energy shipment requires exchanging additional yen for dollars, which increases demand for the US currency, while at the same time weakening the yen further.
At the same time, Japan's stock market has attracted considerable foreign investment. And ironically, many international investors who buy Japanese equities choose to hedge their currency exposure by selling the yen, which adds another source of downward pressure.
So, together, these factors that I just described, and let me just sum it up. So, I described a wide interest rate gap, expensive energy imports, strong demand for dollar-denominated assets, and currency hedging. All of those things have pushed the yen to levels not seen since the mid-1980s.
Japanese policymakers are, of course, well aware of the risks posed by a rapidly weakening currency. Finance Minister Satsuki Katayama has repeatedly stated that the government stands ready to intervene if exchange rate movements become excessive. But, uh defending a currency is expensive. When Japan intervenes in foreign exchange markets, it must purchase yen by selling foreign currencies, primarily US dollars. And so, this is where it gets really interesting. To obtain those dollars, Japan may need to liquidate some of its foreign reserve assets. Since the country's largest foreign assets consist of US Treasury securities, any significant effort to support the yen could involve selling American government bonds. So, you see how it is directly related to the US economy.
This is where the story becomes much larger than Japan itself. Japan remains the largest foreign holder of US Treasuries, and for decades, these investments have helped finance America's growing budget deficits, while also providing stability and liquidity to Treasury markets. Under normal circumstances, modest Treasury sales would likely be absorbed by financial markets without any major disruptions. But, if Japanese authorities are forced to intervene repeatedly or on a much larger scale, which appears to be the case, the volume of Treasury sales could become significant.
There are reports that Japan's holdings of foreign securities declined by approximately $75 billion during May of 2026, which suggests that Japanese authorities may already have begun drawing down reserves. And if the yen continues to weaken, Tokyo may have little choice but to continue selling US Treasuries.
The timing, of course, couldn't be worse. The timing could hardly be more sensitive for the United States. The US Treasury is already issuing enormous amounts of new debt to finance expanding government deficits while continuously refinancing trillions of dollars in existing obligations. If one of America's largest foreign creditors shifts from being a major buyer of Treasury securities to becoming a significant seller, it all falls apart. Treasury yields could move even higher. Um rising Treasury yields, as I explained before, translate directly into higher borrowing costs throughout the US economy. It is going to affect everything from mortgage rates and corporate financing to auto loans, commercial real estate, and federal interest payments as well.
Bond markets do not necessarily require panic to create instability, as I'm sure many of us have already learned. Sometimes all it takes is for one major participant to change direction. And of course, it is fair to say that few participants are larger than Japan.
There's also an important question about whether intervention would even solve the problem at this point in time. History suggests that currency interventions can temporarily slow a currency's decline, but uh they actually rarely reverse the underlying trend unless economic fundamentals change as well. And so, as long as US interest rates remain substantially above Japanese rates, which you can bet is going to be the case, investors will continue to find dollar-denominated assets more attractive than the yen.
Many analysts, if you look at the reports at a if you look at opinion pieces, um you will see that many analysts argue that the long-term solution lies elsewhere. Either the Federal Reserve will eventually need to lower interest rates, reducing the yield advantage of US assets, or the Bank of Japan will need to raise its own interest rates much more aggressively. Without one of these developments, intervention may only buy time rather than permanently strengthen the yen.
Japan's own fiscal position makes the situation even more complicated, and of course, that's the elephant in the room that I want to address very briefly. Government debt now exceeds 250% of the country's gross domestic product, of its GDP, um giving Japan the highest debt-to-GDP ratio among major developed economies. As Japanese government bond yields gradually rise, debt servicing costs are also increasing, and that's bad news. This severely limits how aggressively the Bank of Japan can raise interest rates because higher rates would significantly increase the government's financing costs, and nobody wants to pay more interest. So, policy makers face an extremely difficult balancing act in Japan. Raising rates too quickly risks placing enormous strain on public financing, while leaving rates too low allows the yen to continue weakening. So, you see how they are between um a rock and a hard place. Neither option is particularly attractive.
Global investors and global experts are closely, of course, watching every single development at this time, and you should be as well. Many asset managers believe that the yen will remain under pressure because the interest rate differential between the United States and Japan, as I discussed previously, remains exceptionally wide, and it is expected to remain wide. Now, there also others who argue that if the currency weakens much further, Japanese authorities could launch substantially larger interventions that markets currently anticipate. And so, the uncertainty has increased volatility in foreign exchange markets, and um of course, it serves as another reminder of how interconnected today's financial system has become. A sharp currency movement in Tokyo can quickly ripple through uh bond markets in New York, and um equity markets in London, and commodity markets worldwide, and of course, financial systems across the globe. Everything is interconnected.
So, um there may be early signs that uh the dollar's extraordinary strength is beginning to moderate, and that may be um just some positive news that may uh prevent a crisis. Uh following weaker than expected US employment data, financial markets have reduced expectations that the Federal Reserve will continue raising interest rates. And so, as a result, the dollar has eased somewhat from its recent highs, which allows the yen to recover quite modestly from its record lows. Whether this proves to be a temporary pause, or the beginning of a more sustained reversal, remains uncertain. I tend to think that this is just a temporary pause.
Um what is becoming increasingly clear is that investors are paying closer attention to government bond markets than ever before. The greatest financial risks today are not necessarily found in stock prices as we tend to to think, um but in sovereign debt markets that often receive far less attention and and scrutiny and um commentary in general. So, Japan's weakening currency illustrates, in my opinion, just how closely currency markets, government bond markets, and geopolitics have become intertwined. If Tokyo is ultimately forced to continue selling US Treasuries in order to defend the yen, the consequences will extend well beyond Japan's borders. Um and the consequences will influence borrowing costs, capital flows, and financial stability throughout the global economy. The yen's collapse may appear to be a Japanese issue today, but its next chapter, if you will, could very well be written in America's bond market. We just have to watch and see what happens.
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