Michael Hudson : The U.S. dollar-yen swap dynamics
Today I did a one-hour interview on Treasury Secretary Bessent’s swap of euros (not dollars) for yen to be dissipated in a short-term attempt to stem its falling exchange rate.
As it happened, the record button was not pressed. So here are my notes, because I think the discussion was timely and I don’t want it to go to waste.
The carry trade has made Japan’s economy the world’s largest holder of U.S. Treasury bonds, with $1.2 trillion. But these bonds have been bought on credit, largely by speculators. They are not Japanese savings free and clear.
What arbitrageurs are after: (1) interest-rate differential, and (2) exchange-rate gains (or to avoid losses).
The yen’s exchange rate against the dollar already has sunk to its lowest in over 40 years. That means that speculators who borrowed yen at low rates to buy higher-yielding U.S. bonds and stocks (making capital gains) got a double benefit: When they sell their U.S. financial securities to pay back their yen, it costs fewer dollars to buy the original sum of yen that were borrowed.
You may have charts on this, so I’ll just state the basic principle at work:
My added point: Arbitragers have borrowed yen to buy higher-yielding U.S. Treasury bonds and other securities. BUT: as interest rates have risen as a result of America’s Oil War with Iran, the market SALES PRICE of these Treasury securities has declined.
SO: The price decline may well have wiped out most or even all of the arbitrage interest-rate gain.
Then there is the foreign-exchange rate effect: If Japan borrows U.S. dollars or other currencies to support its exchange rate, then repaying the Japanese banks for their low-interest loans will have a retroactive loss in the shift in Japanese exchange rates.
However, it is more likely that Japan, Korea and other oil-deficit countries will see their exchange rate FALL. In THAT case, arbitragers will receive a bonus in the fact that buying the Japanese yen to pay back their initial loan will not cost them as many dollars as the valuation of the loans they received.
So we’re dealing with a juggling act: currency exchange-rate shifts and the price of the bonds and securities bought on credit, compared to the arbitrage gap between the borrowed currency and the targeted currency in which higher-yielding bonds are issued.
Complications in the yen-dollar swaps
When arbitrageurs borrow yen from Japan at low interest rates (1%) to buy higher-yielding U.S Treasuries (over 4%) and pocket the difference as their profit, the investment has two effects.
First is the effect on the balance of payments and hence the exchange rate between Japan and the U.S. dollar:
Using yen to buy dollar-denominated bonds raises the price of the dollar and weakens the yen’s exchange rate.
The second effect of borrowing yen to buy dollars creates a FUTURE obligation to unwind this trade. The question is, WILL THE YEN/DOLLAR EXCHANGE RATE SHIFT? If so, how will this effect swaps of yen for dollars when repayment time comes?
All buyers of U.S. Treasury bonds over the past year have seen U.S. interest rates rise. That means that the price of the existing bonds being bought has declined. So the initial arbitrage gain in the interest-rate differential may be offset if U.S. bond prices go down.
It also would be offset if the U.S. dollar’s exchange rate weakened. If the dollar weakened because of its balance-of-payments deficit (mainly affected by international capital movements more than trade), then the yen-debt that the arbitrageur has to pay back the Japanese bank will have risen – by the appreciation of the yen against the dollar’s falling value.
Why does the U.S. Treasury want to dissuade Japan from raising interest rates?
If Japan raises its interest rate, this will leave less room for speculators to borrow low-interest loans of yen to buy higher-interest U.S. bonds – unless U.S. bond interest rises even more than the Japanese interest rate. But so far, U.S. interest rates have indeed risen faster. But as noted above, their rising interest coupon lowers the price of these bonds, so the loss of principal may exceed the interest-rate margin.
The problem for the U.S. Treasury is that if Japanese interest rates rise and lead speculators to sell bonds, that will tend to lower bond prices – meaning that existing bonds will yield higher interest rates.
The Trump administration doesn’t want this to happen. So Bessent suggested an alternative to Japan’s desire to raise interest rates to stop the decline in the yen’s exchange rate.
Instead of raising its interest rates to attract foreign loans into the yen (and causing speculators to sell their U.S. bonds), the U.S. Treasury will simply arrange a swap. It (or the Federal Reserve system) will lend the Bank of Japan tens of billions of U.S. dollars and receive yen currency back. This way, the bond market and foreign exchange market will be unaffected. There will be no upward pressure on U.S. interest rates (or a downward U.S. dollar exchange rate against the yen as dollar assets are sold to pay Japanese banks).
Bessent’s twist was not to sell U.S. dollars to buy yen. That would have weakened the dollar. Instead, Bessent sold Treasury holding of euros.
That weakened the euro, while leaving the direct dollar/yen rate unchanged (except to the extent that supporting the yen’s exchange rate made it less profitable for arbitrage speculators to unwind their dollar-yen swaps, because they cannot buy as many yen as they borrowed – if indeed the yen’s exchange rate rises).
And from the U.S. Treasury’s vantage point, the euro is likely to keep weakening as a result of the rise in oil prices forcing Europe’s trade deficits to increase.
So the U.S. Treasury can buy replenish its supply of euros later. It probably wanted to get rid of what it had, foreseeing that the EU might ask for dollar SUPPORT for the euro by this autumn when oil prices rise and force the EU trade balance even deeper into debt.
Now, let’s look at the longer-term context for foreign-exchange gains and losses
The world is moving into an energy crisis by this September. The U.S. National Petroleum Reserve (NPR) will be largely sold off to keep oil prices low, and they will rise as a result of the disruption in Persian Gulf oil trade. Oil prices, fertilizer prices, crop prices and other prices will rise – forcing many countries into deepening trade deficits.
These deficits will lower many foreign countries’ exchange rates. They may try to minimize this effect by raising prices to borrow short-term loans to cover their trade deficits. And Japan will be one of the most seriously affected countries, because of its oil-deficit status, and also because its political decision to re-arm and support Taiwan separatism against China has led China to stop key exports of rare earths and other raw materials to Japan. So Japan’s economy faces supply interruptions.
These interruptions will reduce its ability to export industrial products, worsening its export income while its cost of imported oil rise.
The effect will be to weaken the yen’s exchange rate against the dollar. This will make it more expensive for the Bank of Japan to obtain the dollars to pay back Bessent’s U.S. swaps.
Japan will have used the yen to prevent further currency depreciation. Instead of obtaining the dollars to do this by unwinding its carry trade by lending arbitrage speculators to sell their bonds and buy yen at today’s exchange rate, a rising dollar (and falling yen) will make the arbitrage gains even higher.
But how will the Japanese government pay obtain the dollars to pay back the U.S. Treasury for the dollar swaps that it has taken on and spent? Japan’s government will take a foreign-currency loss as buying dollars to pay back the U.S. Treasury swap deal will increase the dollar’s exchange rate. That will require more yen to pay back the dollar valuation of the swap agreement.
Another twist: Rising interest rates increase the federal budget deficit of the United States and Japan alike. Governments will have to pay bondholders more interest, deepening the budget deficit. This would tend to force cutbacks in other categories of government spending.