Bessent's Yen Rescue Expands Fed Balance Sheet by $60 Billion

The U.S.-Japan yen rescue is being financed in a way that pumps dollars into an already-overflowing economy.

The U.S. is printing dollars so Japan can buy yen — an unprecedented financing method that expands the Federal Reserve's balance sheet just as Chairman Kevin Warsh has pledged to shrink it. Treasury Secretary Scott Bessent wants the Fed to drop the $60 billion cap on the emergency facility being used to lend to Japan, and has pledged to do "whatever it takes" to help.

"The U.S. authorities were worried about potential implications of this for the Treasury market if it had been done in a more traditional way," said Nathan Sheets, global chief economist at Citigroup and a former Fed Japan specialist and undersecretary of the Treasury for international affairs. "Bessent's saying here that he's watching the U.S. Treasury market very closely and as a corollary that there are some potential tail risks that he needs to manage."

The intervention follows the yen's slide to near ¥164 per dollar in late July, its weakest in real, trade-weighted terms in data going back to 1970. Japan confirmed the joint operation Monday, with central bank data indicating Tokyo may have spent as much as $36.58 billion buying yen Friday, after a solo intervention a day earlier estimated at roughly ¥8.45 trillion ($52.8 billion). The yen strengthened almost 4 percent last week, its biggest weekly jump in two years, then surged more than 1 percent Monday to ¥155.20 before easing to about ¥157.55 by Tuesday.

The stakes are high because Japan holds more than $1.1 trillion in U.S. Treasurys, the largest foreign position, and repeated solo intervention raised the prospect that Tokyo might sell some of that stack to fund yen buying — sales that could depress Treasury prices and lift U.S. borrowing costs at a moment when the 30-year yield recently touched its highest level since 2007.

A Carry Trade That Refused to Die

The yen's weakness is not a simple case of a soft currency. In just over two years the Bank of Japan has raised rates five times, while the Fed has cut six times, narrowing the gap between the interest available in the two currencies from 5.6 percentage points to 2.75 points. The gap between 10-year U.S. Treasurys and Japanese government bond yields has dropped from a 2023 high above 4 points to below 2 points.

The carry trade of selling yen and earning interest in dollars should have become less attractive as policy rates converged, strengthening the currency. Instead it kept working because traders shifted to 2-year bond yields, where the gap widened this year as the BOJ stayed cautious and expectations of Fed rate rises grew. Speculative bets against the yen reached their highest in Commodity Futures Trading Commission data going back to 2010.

Heavy speculative positioning can end messily when it reverses, swinging global markets violently as speculators are forced to cut borrowing in unrelated areas. That is what happened in the 2024 carry trade reversal, when a hawkish Bank of Japan and weak U.S. jobs figures triggered a 12 percent one-day plunge in the Japanese stock market and big falls in U.S. and European stocks. Sheets said it makes sense to try to reduce the risk of a "sharp nonlinear correction."

The Fed's Balance Sheet Grows as Warsh Wants It Shrunk

The way the U.S. intervened suggests Bessent is trying to avoid the standard method where Japan sells some of its Treasurys, putting upward pressure on yields. Instead, the Fed is lending Japan dollars in return for temporary ownership of Treasurys in repurchase agreements — not quite quantitative easing, but like QE it expands the Fed balance sheet and pumps billions into the economy.

The problem is that printing dollars to finance the intervention makes it less likely to work. It avoids higher Treasury yields and eases monetary conditions — adding fuel to the stock rebound — both of which work against the stronger dollar Japan wants. The yen has already weakened a bit from near 155 to the dollar about three days ago to almost 158.

The real measure of effectiveness is whether the intervention forces the market to reconnect the yen's level to the interest-rate gap between the U.S. and Japan. The surest way is for the BOJ to be clear that more rate rises are imminent. The BOJ held its policy rate at 1 percent last week while flagging room for a hike as soon as September, and derivatives markets put the odds of a quarter-point September increase at roughly 40 percent, up from 30 percent a week earlier. Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, told Reuters, "I feel like a September rate hike is a done deal."

Bessent made a parallel point on CNBC: "You can give market signals with intervention, but it's policy that turns it." Mark Sobel, a former Treasury official now at the OMFIF think tank, told Reuters that "if Japan wants a higher yen, it needs to address the monetary and fiscal policy concerns," citing the country's heavy debt load and accommodative stance.

Intervening now makes some sense, but the way it's being done should worry both that the Treasury is concerned about a hidden problem in government debt, and that the Fed is being roped into easing monetary conditions when it should be moving to tighten them. The last time Washington bought yen to strengthen the currency was 1998; a 2011 coordinated action aimed to weaken it after Japan's earthquake and tsunami. With Bessent pushing to enlarge the FIMA facility and Warsh opposed to balance sheet expansion, the intervention has opened a new fault line between the Treasury and the Fed over who controls monetary conditions.

This article is for informational purposes only and does not constitute investment advice.