U.S. Treasury's Euro-Yen Exchange Rate Intervention: The Hidden Reason for Selling Euros Instead of Dollars

Wall Street Ajjae revealed that the U.S. Treasury sold euros and bought yen late last month. Selling euros instead of dollars is a very peculiar transaction, and Wall Street Ajjae analyzed this transaction as a strategic move to lower long-term interest rates. This issue leads to the interpretation that the entire U.S. economy is constrained by the upper limit of long-term interest rates.

Wall Street Ajjae explained that due to war financing, Treasury bonds have surged, and the supply of long-term Treasury and corporate bonds that the market needs to absorb is expanding in various ways. This is acting as a red flag for the market. Wall Street Ajjae also added that the market's interpretation of the Fed's credibility issue is only half-correct. He emphasized that a significant part of the real cause is supply rather than credibility.

Wall Street Ajjae stated that the point where clear negotiation signals emerged recently in the U.S. was immediately after the 10-year yield broke above 4.7%. These two trends can be seen overlaid on the screen's timeline. For the administration, long-term interest rates are a market constraint that impacts the entire policy agenda. The more policies Trump and Biden want to push, the more they need to suppress long-term interest rates first.

The U.S. Treasury intervened using funds from the Exchange Stabilization Fund (ESF), amounting to approximately $200 billion. Unusually, the method involved selling euros it held to buy yen, rather than directly selling dollars. Since the U.S., as a key currency nation, directly selling dollars to intervene in other countries' foreign exchange could itself be read as a signal betting on dollar weakness, the Treasury appears to have chosen an indirect route between the euro and the yen without touching the dollar.

Wall Street Ajjae explained that Japan is not a country short on dollars and has sufficient means of self-procurement. Nevertheless, the reason FIMA is emphasized is that this window can also be used by countries without a standing currency swap line with the Fed. Countries like South Korea can also use this window. While currency swaps are disclosed relatively quickly, FIMA only announces the total amount used, limiting the stigma effect. If a specific country uses a swap line due to urgent dollar needs, it could raise concerns about a foreign exchange crisis, but FIMA has limited stigma effects and similar interest rate conditions to currency swaps.

The Fed defines PIMA as a means of providing dollar liquidity, not a currency policy. Besant, on the other hand, views this window more broadly. He argues that this window should be used to proactively block the path where large-scale selling of U.S. Treasury bonds leads to a surge in long-term interest rates, causing market instability, and eventually escalating into a tightening of dollar funding markets. Therefore, the Treasury appears to want to expand the use of the same window to include bond market defense measures.

It is known in the market that the proportion of unhedged foreign currency assets held by Japanese life insurance companies is around 60%. This suggests that there is a large volume that could be unwound all at once to avoid losses if the yen strengthens. However, there is an optical illusion in this figure. Japanese life insurers also sell many insurance products denominated in dollars. Since they will have to pay out insurance benefits in dollars later, if they hold dollar-denominated bonds as assets to match these liabilities, their assets and liabilities move together regardless of exchange rate fluctuations, creating a natural hedge. A significant portion of these positions is included in the 60% figure, making it difficult to consider all of it as carry trade volume that would be unwound if the yen strengthens.

A narrowing interest rate differential has implications for the risk of yen carry unwinding. The driver of yen carry is ultimately the interest rate differential between the two countries. The profit source comes from borrowing cheaply in yen and earning high interest in dollars. However, if that momentum has already decreased to about 2 percentage points, then the incentive for new carry trades, or the size of accumulated positions, may not be as large as when the interest rate differential was wider. This suggests that even if the yen strengthens, the volume to be unwound may not be substantial.

The remaining key is speed rather than scale. If the exchange rate moves within a stable range, the impact is limited, but if it rapidly drops or rises in a short period, the situation changes. The pace of the Bank of Japan's interest rate hikes and the extent to which Japanese pension funds increase investment in domestic assets can act as variables controlling the speed of the yen.

The balance sheet review task force is primarily composed of three individuals: Rajan, Dynan, and Stein. Rajan has emphasized the necessity of reduction, while Dynan, conversely, has highlighted the benefits of a large balance sheet. Stein assessed that the composition of assets held is more important than the balance sheet size itself. With these three individuals holding subtly different views leading the task force, how their opinions will converge remains uncertain.

Wall Street Ajjae projected that the U.S. market might not fare well after November. Of course, various information will emerge between now and then, requiring continuous updating and discussion of new information. However, based on current information, while there might be some further movement after November, next year is expected to be a very risky market.

There is a kind of stealth coordination between the Treasury and the Fed. The Fed is currently purchasing short-term Treasury bonds through a program called RMS, with the justification being the management of bank system reserves. The scale of this is significant. From January to early July of this year, the Fed's short-term Treasury bond purchases amounted to approximately $250 billion, of which $160 billion was pure RPS execution and $90 billion was reinvested from existing MBS principal repayments. If the Fed consistently purchases short-term bonds, the Treasury can increase the proportion of short-term bonds in its bond issuance. This allows the burden of issuing medium- to long-term bonds, such as 10-year and 30-year maturities, to be postponed.

Stablecoin issuers hold large amounts of U.S. short-term Treasury bonds and government money market funds as reserve assets. The more this industry becomes institutionalized and grows, the more the demand base for U.S. Treasury bonds increases. Looking at the growth trend of the total market capitalization of stablecoins in the chart on the screen, it has grown very rapidly in recent years.

The last resort is bank regulatory reform. The direction is clear: to ease balance sheet constraints on banks and dealers to allow them to hold and intermediate more Treasury bonds, and at the same time, to redirect some corporate financing from the corporate bond market back to bank lending. In short, the intention is to expand the role of banks in the capital market and restore them as central players.

Wall Street Ajjae explained that none of the five aforementioned measures alone will solve the situation instantly. The first and second measures reduce the incentive for foreigners to sell Treasury bonds. The third measure postpones the timing of long-term bond supply, and the fourth measure, stablecoins, creates new demand. The last, fifth measure, easing bank regulations, increases the market's absorption capacity. Thus, each measure works by absorbing shocks incrementally.

Wall Street Ajjae mentioned that the M2 analysis disappeared from the Fed's monetary policy report in early 2016, and now, after nearly 10 years, the M2 indicator has been re-added. This indicates that the importance of M2, a monetary aggregate indicator, is again being highlighted.

In 1979, the Volcker Fed attempted to curb inflation by directly controlling the growth rate of the money supply, known as the monetarist experiment. However, over time, problems arose with this experiment. As financial products diversified and methods of payment and saving changed, the velocity of money began to fluctuate. These changes made the M2 indicator less useful as a direct policy tool than in the past.

Wall Street Ajjae explained that the Fed is not aiming for a specific money supply target but rather adding another indicator. This means that in addition to inflation, employment, and inflation expectations, they will now also look at M2 and its velocity to cross-verify how expansionary or contractionary current policies are. This is expected to contribute to increasing the credibility of policy decisions.

Wall Street Ajjae emphasized that the various measures described earlier have one commonality: a significant portion of their form ultimately passes through the hands of the Fed. This suggests that the government's efforts to stabilize long-term interest rates would be difficult without the cooperation of the Fed.

Wall Street Ajjae stated that all discussions ultimately converge on one question: Will the Fed in Washington move in the same direction as the administration over the next few months? The order in which the answer to this question will be confirmed is virtually set. The first part to be confirmed is the Jackson Hole keynote speech on Friday, August 28th. Subsequent announcements and actions until the end of the year will be closely watched.