Sometimes I get obsessed about certain topics to the point where I can’t stop reading about them and every adjacent topic required to understand that topic. The Japanese Yen has been the beneficiary of my passionate love for the past few months. Ask any of my friends and they’ll tell you how annoying I can be about it if you trigger me about it. Rather than re-explaining it all multiple times I thought why not just write an article to consolidate my knowledge into one blog post. This is that post.
I am not a macro-economics expert — far from it. My highest qualification is being a computer science dropout in Sydney. If there’s something that I’ve got wrong about this or you’d like to get clarification on, please do let me know as I’m always eager to learn and improve!
Okay disclaimers aside, lets get started. In order to understand why the Japanese Yen impacts your life, we’ll need to set a good amount of context first.
Introduction
The modern economic system relies one key driver to keep the party crashing down: growth, measured through GDP. As long as the rate of growth is fast enough, past debt does not matter because the spoils of the future will pay off the debts of the past. This strategy has largely worked for many economies and currencies since the US Dollar got off the gold standard and ended convertibility in the 70s. We now live by a corrupt philosophy called Modern Monetary Theory which states government spending should not be restrained by debt because they can simply print money out of thin air.
When we think about GDP there’s two key factors we need to consider:
How many people are there that can work? This can be chalked up to the number of able, working people.
How effective are these people at working? This is basically our level of technological advancement.
This has largely been okay since we’ve had a few big drivers of growth. The first being the world simply has more people in it. Since 1970, we’ve more than 2x’d the population from 3.7b people to 8.09b. That’s a pretty productive world because there’s more people that can work!
But what about our advancement in technology? Well that’s a whole new story. Below is the chart of total GDP of the world for the past 300 years. When we discovered MMT (modern monetary theory) it probably made sense because even from 1950 to 1970 the world’s GDP increased from $10t to $26t. “Debts be damned when we’re growing like crazy”, said every government!
The party has been largely okay for a long time, although somewhere along the line governments forgot two key points:
Although global GDP may increase, your country needs to be increasing it’s GDP and play its part in global growth
You should monitor your rate of growth against your GDP to ensure you’re not putting a huge debt saddle on yourself
You would think that’d be common sense. Unfortunately not. When you control the money printer, the allure of the button can be hard to resist.
Debt and GDP
This is kind of the whole premise of what we’re going to be discussing: how much are you growing versus how much debt have you taken on. If you want to simplify this, think of it as your credit card bill versus what your future income earning potential is.
Unfortunately Our World in Data doesn’t have beautiful graphs so I’ve had to pull these from this data from the International Monetary Fund (IMF) and it goes back 200 years. I included key countries so you can better understand how everyone ranks against everyone.
As you can see there’s one country that is MASSIVELY over relative to everyone else… turns out that’s the country that this entire article is based off. Okay so why are these huge debts not an issue? Well I oversimplified a little before. The government is like a degenerate YOLO gambler that says “look bro, as long as I can afford my repayments every month, who cares what my debt is!”. I promise you that’s not false.
Now how are these interest rates set? Well that’s another rabbit hole about how central banking and bonds work. I’ll try to avoid going down that rabbit hole by simply saying that part of Japan has racked up a ton of debt. This has been by artificially keeping its cost of debt low by printing their currency to buy debt. If that sounds like a lot to digest don’t worry. Basically the Bank of Japan (their central bank) prints money and does funny things. One example of this is the fact they own ~11% of the stock market from money they created out of thin air.
From the period of 2013 - 2023 Japan basically engaged in it’s funny business called Abe-nomics by artificially keeping interest rates as low as 0% or sometimes even negatively! This is a key detail to remember. Why? Well because it doesn’t matter how much debt you accrue if your interest rate is 0% (you will never have to pay money for repayments). Never mind you’re the party that sets the interest rate at 0 though. Life is good! Right? We’ll check back with Japan later.
Okay lets turn our attention to the second offender on the list when it comes to Debt to GDP: the United States. They’ve also been having fun printing lots of monopoly dollars to keep funding their wars and international aid.
United States
For the past 5-10 years, as interest rates have been low their interest repayment bills haven’t really been that problematic. As they raised from 0% to 5% that tax bill suddenly got really big.
I’m going to use 2023 numbers since they’re complete. The US federal government earned $4.8t in tax revenues during the period of 2023. They spent $6.35t during the same time leaving them in a deficit of $1.5t. What are they spending this money on? The table below outlines everything we need.
As we can see net interest payments costed $635b in 2023 alone and eventually on-pace to $1t by 2028 (assuming high interest rates).
Now the question is where does that shortfall come from? Well this is where it starts to get a little more interesting. Remember, as long as they can service the repayments, the party can keep going on. It doesn’t matter how much the total bill is.
The government covers this shortfall by issuing bonds. The literal definition of risk free rate in the world is the yield that US government bonds pay out, they’re supposed to be the safest instrument for investors to park their money and earn cash in. So what the US government does is take full advantage of this by issuing new bonds in order to pay the interest of the old bonds maturing (being due for payment). It is quite literally Terra/Luna but the entire world participates in the ponzi scheme. When they can’t borrow, the Federal Reserve can step in and print fresh US dollars to buy the bonds. This is called an “Open Market Operation”. The FED can also do more funky things like buy stonks and other things, this is what the Bank of Japan does as we outlined earlier.
What’s interesting about bonds is that the more you issue/sell (add supply to the market), their price goes down and their yield goes up. This means investors can earn a high rate of interest the more bonds are issued on the open market. It also means the government pays a higher cost of borrowing capital.
Remember: large deficit → more bond sales → lower bond prices → higher bond yields = more expensive to borrow.
Coming back to Japan
Konichiwa, now that we’ve taken a little detour to the United States, it’s time to come back to Japan. We have two countries running two different strategies at a macro level now:
Japan printing lots of money to artificially keep bond yields low therefore borrowing cheap (close to 0%)
United States raising interest rates to curb inflation but also paying higher yields on debts as more bonds are issued
As a result this opens up what is known as a “Carry Trade” for investors. The idea is you can borrow Yen, selling Yen for USD (causing downwards pressure on the Yen and the USD stronger) then lending the USD to earn 5% while paying close to 0% on the borrowed Yen. It’s almost like free money to investors who can skilfully play the trade (although many lose money). If you look at the trading volume of USD/JPY it’s one of the most liquid in the world with trillions of dollars in volume!
There’s a few things you need to understand about this chart at a meta level before we talk specifics of it.
The higher this chart goes, it means the Yen is getting weaker. A weaker Yen isn’t necessarily bad since exports become more competitive (cheaper for other countries buying things priced in Yen), although imports become more expensive (buying things in USD costs for more for the Japanese people).
The lower this chart goes, it means the Yen is getting stronger. This makes imports cheaper but makes exports less competitive.
Given the choice between the two, Japanese generally chooses a policy of a weaker Yen in order to promote exports as that is how its economy thrives.
The problem comes when the Yen swings too hard in a particular direction as it throws their economy out of balance. From the start of 2024 to July (Point 3 on the chart, the Yen devalued close to 12.5% (140 → 160) in 7 months! This is not healthy given the rapid rate of change. So what the Japanese authorities did was use their USD reserves to buy Yen, thus making it stronger.
As you see on the chart above, these “interventions” are when the price drops sharply (point 1 and 2). They made multiple during that period but I’m just highlighting the main ones. The total cost of these interventions was around $50b over the course of a few months. However, each intervention led to the price rapidly climbing back to where it was and shooting past!
So what options does Japan have realistically:
Continue to sell USD for JPY: not sustainable and also a waste of money as price comes back to where it was.
Raise interest rates: not feasible given massive debt amount. Most mortgages in Japan are variable based. Increasing the cost of capital would screw their own economy, but solve the problem.
But there’s a third option! Start selling treasury bonds. In a crazy twist of events, Japan is the largest holder of US bonds in the ENTIRE WORLD. The below is straight from the US Treasury.
Japan comes in #1 with $1.1T worth of US bonds. Now remember back to our section on bonds, if Japan started selling these bonds on the open market to defend their own peg, it’d cause bond prices to go down and the yields go up, which in turn makes borrowing expensive for the US government and the rest of the world! Yes. If that was to happen you’d need some form of quantitive easing to remedy the situation. This is the crux of why USDJPY is the most important chart, hidden within it is the interconnected relationships of the global financial economy.
But as we can see in the USDJPY chart, it isn’t going up anymore, it’s down bad. So what happened?
On July 31, 2024 they did what no one thought they would do: raise interest rates.
Even though the raise was 0.25%, it made the carry trade less profitable which is problematic when you have very large amounts of leverage being applied (evident through the multi trillion dollar trade volume). As a result, a lot of the leverage in the USDJPY carry trade unwinded in a single day causing an instant market crash as traders/investors needed to sell other assets to cover the shortfall.
6 days later they came out with this statement.
Lmao. So obviously they can’t raise rates as hard as they’d like because the entire global economy is watching them and making stonks go down, especially before the US elections is not desirable. However, their willingness to raise rates creates an additional problem: as the carry trade unwinds, markets will go down. But maybe Japan says that’s okay.
Checkmate though: if they continue to raise rates then the cost of their borrowing goes up and they already have A LOT of debt (remember the 260% debt-to-GDP ratio at the start of this article). The only way to get out of that scenario would be to print Yen to pay back the debt, which would in turn weaken then Yen, this time from their own undoing.
But here’s where it becomes more interesting. The Federal Reserve recently cut rates by 50 bps. While this is great for the cost of capital going down, it means the carry trade is less profitable and will further unwind putting downwards pressure on markets and creating a stronger Yen. The stronger Yen would be bad for their economy as it makes their exports less competitive. The Japanese need the carry trade, and have relied on it for the past 10-20 years.
Closing
While it did take a while, as you can see the Yen is intrinsically very interconnected to the SS given the large amount of US debt it holds on balance sheet. While many think that Japan is just a nice country to be a tourist in, the state of their economy has a very direct impact on the global economy. I don’t claim to predict what will happen, however I hope that through this article you have a great appreciation and understanding of the interconnected nature of all these variables.
You should hopefully now be able to read a jobs report data on Japan and be able to think how it will impact the Japanese economy, the Yen and eventually the bond yields at a high level.
If you found this all super interesting I highly recommend reading Arthur Hayes’ blog
and/or picking up a book on macro economics. You’ll learn so much and hopefully have fun realising how history, economics, money and politics are ever-so intertwined.
