Brad Setser on the US's Unusual Japanese Yen Intervention

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Odd Lots Podcast Introduction

2:00Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, I think I know the answer to this question, but do you ever write to-do lists? No. Yeah. I figure. No, I'm not. No. Well, I make a half-hearted attempt every day where it's like podcast recording one, podcast recording two, do the newsletter, reply to the following emails. Yeah. But as of last week, I have seen the most epic to-do list ever.

2:31Oh, yes, yes. Presumably you saw this. Yeah, yeah, yeah. I saw the Scott Besson to-do list. It was basically like buy the yen, right? Right. So U.S. Treasury Secretary Scott Besson, there was a photo taken of him. Presumably he did this on purpose. One would hope, but he had a to-do list and it basically just said buy Japanese yen.

Scott Besson To-Do List

2:53And he put in the JPY acronym- Yeah. So there's no ambiguity. Five to 10 billion. Yeah. So it was pretty clear that he was not referring to personal purchases in some vacation. If that's the only thing on the Treasury Secretary's to-do list, he's not that busy, right? He's not, but he presumably is fairly busy. We know that the yen had been weakening dramatically. We know that there has been a recent sharp strengthening. There's always talk of a yen intervention here and there. I don't really understand fully why the yen is so weak, why the U.S. feels compelled that it's

3:27important to get involved in that market, et cetera. I have many questions. Yeah. So the U.S. did intervene together with Japan in the yen to stop it from weakening. And what's really interesting about all of this, I mean, we love big foreign currency stories anyway, but what's interesting is this was kind of a new type of intervention. So the U.S. actually sold euros, which was very interesting. And they also used a Fed repo facility that I had completely forgotten about as well. So there are all these interesting questions about this particular

4:01incident, let's say, including the big one, which is, will this be enough to stop the yen weakening? And it's still very surreal to me whenever I look at a chart of the dollar exchange rate. The yen will always be 110 to the dollar for me because that was my allowance when I was there. I got a thousand yen every week and it was like roughly $10. And so I have that stuck in my head. And whenever I look at the chart, it's now at like 155. It's kind of crazy. Yeah. No, it's pretty wild. I mean, for so long, for like the first half of our careers,

4:34the story was like strengthening and strengthening yen, lower and lower rates at the long end of the Japanese yield curve. People used to talk about the widowmaker trade because many people had gone short various forms of Japanese paper on the expectation that it all blow up in some way. But it is really blown up, but it's been quite a reversal on both the rates in the end. And again, the question I have in addition to the tools is, why is this an important thing now for the U.S. to get involved and why do we feel so? I have many questions.

5:04All right. So whenever we have big questions about capital flows or FX moves, we shine our Brad Setzer bat signal into the sky and he magically appears on the podcast. So we do, in fact, have the perfect guest. We are speaking once again with Brad Setzer, Senior Fellow at the Council on Foreign Relations. So, Brad, thank you so much for coming back on Oblots. It's always fun.

Interview with Brad Setzer

5:27Maybe just to begin with, let me ask the obvious question. If your currency is weakening to the degree that you think an intervention is necessary, why doesn't the BOJ, the central bank, just raise rates?

5:43That is a very obvious question. For whatever reason, the Bank of Japan has been very slow to raise rates. So the short-term policy rates, about 1%, it is 1%. Inflation is clearly above that. They're different measures. Inflation has been above that for a long time.

6:03The stated reasons for the hesitation is, you know, the Bank of Japan has worked for so long to get inflation back to 2%. They don't want to prematurely cut off this shift in behavior to kind of, they don't want to fall back into the zero rate, zero inflation economy. I think there's also probably a few technical reasons. I'm sure that Ueda wanted the yield curve to steepen, and it has a lot, before short-term rates went up. And, you know, short-term rates affect the cost

6:39of all the yen deposits. So they impact the liability side of the banking system. The banks have a lot of low-yielding assets on their balance sheet. So does the Bank of Japan. So there may be some concern about pushing up the cost of funding on the banking side too fast. The theory of some in the market, not me, is that this is out of concern about how it impacts the government's overall funding cost. And if you pushed up short-term rates, that would push up the fiscal deficit and interest cost too much. I think that's a little overstated,

Yen Weakness Explanation

7:13but that is certainly one of the considerations. I want to ask about why the yen has been so weak in the first place. But I actually, before that, maybe we zoom out bigger because like weakness in East Asian currencies in general has been a story of 2026. And, you know, it's not obvious to me why East Asian currencies at all would be particularly weak these days, because all I ever read about in headlines is extraordinary, you know, current account surpluses, not in Japan per se.

7:46Well, the Korean one, yeah. The Korean specifically would be the big one. It's not intuitive to me at all that at a time when like the big chip makers are making money hand over fist, that they would be particularly weak currencies. Why don't you give us this sort of view from the Asia-Pacific view generally, and then the Japan-specific view on this year's currency moves? Well, look, you're right. Like the global trade surplus is now all in East Asia. The chip, you know, basically San Francisco decided to spend a lot of money on kit that

8:19basically comes from, you know, in the first instance, Japan, Korea, and Taiwan, but feeds into a lot of parts from Japan. It's pushing, you know, it's helping China too. So, you know, we have like really record trade surpluses throughout Asia, East Asia, except for Japan. We'll get to Japan later. And like, you know, Korea's current account surplus is going to go from 100 billion and change to somewhere between three and 400 billion. Massive. You know, Taiwan's is probably going to double. And, you know, it was big to begin with. So we're doubling means going

8:52from like 15 to 25 to 30 percent of GDP. These are insane numbers. With Taiwan, it's a bit different. The central bank doesn't want its currency to strengthen. It has engineered a weakening of the Taiwan dollar compared to last year by reversing prudential regulations, basically letting the lifers unhedge their foreign assets. And then with Taiwan in particular, it's almost one company, TSMC.

9:24And you can kind of lean on that company to tell it when it converts and when it doesn't. Bloomberg actually did one of the best stories I've ever seen about the central bank of China, Taipei, and how it is managing Taiwan's dollar without actually using its balance sheet. Korea is different. Korea has been strange. It's been this story where the better the news is for Korea. The more the Korean stock market goes up, the more foreign holders of Korean stocks have to sell because they're hitting concentration limits. And that has created a weird situation where good news

9:58for the equities, for Korea's equity, so, you know, Hynix and Samsung, was leading to an outward flow and producing record weakness in the Korean won. That is layered on to outflows from the pension system. That is layered on to this whole story about, you know, Korean day traders used to buy levered US ETFs, single stock ETFs, and then Korea let them buy levered single stock Korean ETFs. And that didn't turn out to be a great idea. But, you know, it's sort of we end up with a world where you have this

10:30enormous positive terms of trade shock, enormous, that is producing record weakness. And that's in the it's in that context where we can think about the yen as being another of these country currencies that is, you know, kind of fundamentally okay. Japan has a current account surplus of 5% of GDP. It's investment income. It's not trade. Its trade accounts would be improving but for oil, thanks to the AI stuff. It's got one of the biggest foreign asset portfolios in the world.

11:02The government of Japan has, you know, still probably close to $1.2 trillion in reserves. That's a big number. It has $900 billion plus in the government pension fund, foreign assets. That's a big number. GDP is now down to $4 trillion. So, you know, the government is sitting on a foreign asset position of close to 50% of its GDP. The weakness has been throughout Asia a bit counterintuitive, but for slightly different reasons. And with Japan, you obviously have

11:32the very low-rate story as a central part of it. What if you could use AI to research your investment portfolio and ask, find profitable mid-cap energy companies with growing cash flow? Which AI infrastructure stocks appear undervalued? Or rank stock opportunities based on valuation, growth, and risk? With

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Currency Intervention Discussion

14:24So, when I hear the words currency intervention, I often associate that with currency speculation, right? And you hear central banks will come out and say like, oh, stern words to the speculators, you better watch out and that sort of thing. With Japan, do we have indication of how much of this is actually speculation versus, to your point earlier, like actual outward investment?

14:54There's a bit of speculation around the yen. You know, there's not a clean measure of the speculative flow. But like, you know, look, the yen was one of the lowest yielding currencies. So, you, it was a typical funding currency. I don't think the carry trade was on an enormous scale, but there were certainly hedge funds, others, who more or less thought that the Ministry of Finance was going to allow the yen to weaken beyond what it had weakened before. And since, you know,

15:29the yen, shorting the yen is positive carry. There's a higher yield on dollars than on, on yen. As long as you're, it's stable, you make a little bit of money. And if the yen depreciates, you make a lot more money. So there was a bit of speculative betting on it. Not a ton, I would say. And then you have weird hedging dynamics. So there's a little bit of a dynamic where when the Nikkei goes up, foreigners holding the Nikkei need to hedge a bit more because some do partially hedge. When the NASDAQ goes up, the GPIF doesn't hedge. So it doesn't generate an

16:01offsetting hedging flow. And then despite all the hedge America stories from last year, in Japan, the key fixed income hedged investors seem to have gone a little bit less hedged. The life or hedge ratio has come down. So you don't, so a lot of it is not quite your classic speculative flows, although there's a bit of that. A lot of this is hedging flows amongst real money investors. So that does add a little bit of a different dynamic. But I don't discount the fact that a bunch of

16:31investors, including a bunch of hedge funds, were basically making a bet that the yen would go to 170 because Ueda was behind the curve. So let's talk about it from the U.S. perspective. What is the reason that the weakening of the yen is something that would or should concern the Treasury Department?

16:54Well, I think the classic concern, which hasn't been the concern that Secretary Besant has articulated, is that extreme weakness in East Asian currencies gives East Asia a trade edge over American producers. I mean, classically, a weak yen is bad for Detroit. A weak Korean won is bad for Detroit. It's really, you know, the traded goods pressure, most classically through the automotive sector, that has been the traditional driver of this. And to be clear, we are like, you know, the wands come

17:30back a bit, but 1500 is a crisis level of the won and Korea is not in a crisis. 160 is an insanely weak yen on any Big Mac index. It pushes the yen below in inflation adjusted terms where it was in the 1970s. We're back to the 1960s. These are extreme undervaluations, in my view. And so in that sense, the classic concern would be that this gives all these guys a huge edge over American manufacturers. That hasn't been what Besant has emphasized. He's emphasized, well, the weak yen is

18:04putting pressure on the won is adding to this generalized malaise, bizarreness, where good news is bad news for a lot of Asian currencies. And then there's a sense that this could create pressure on the treasury market. Now, to be clear, if the yen just falls, that makes the value of Japanese investments in treasuries higher. So the impact on the treasury market would come if the Japanese resisted that, used their reserves, and the excessive use of their reserves or the use of

18:38their reserves started to put pressure on the treasury market because they have to fund, they would fund it by selling treasuries. So I think part of Besant's theory of the case is that by joining with the Japanese, first of all, you know, we're supporting the yen from an incredibly weak level. It's arguably overshot. It has decoupled from five year or 10 year rate differentials for the past several months, past year even. And by helping the Japanese, we're helping a friend. That's what

19:10the president says. And we can jointly intervene in a way that reduces the possible pressure on the treasury market. That would be, I think, the explanation I would give. But I, you know, Besant hasn't been, he's more, I mean, the president said it was to help a friend. Besant has said it's to avoid destabilization throughout the Asia currency complex. Why did they do it in euros? Or why did the U.S. do it in euros? They sold euros. I mean, you know, some of it is just Secretary Besant being

19:40a former currency trader wanting to have presumably a bit of fun. You know, we have euros. We can use euros. We have a few more dollars, but only a few more dollars. I mean, you can debate. I mean, this was clearly an intervention. But, you know, when you shift your the composition of your reserves around, sometimes that's not even viewed as intervention because you're not selling your currency to buy another guy's currency. I think he presumably did it because he wanted to be a bit cute and say, well, this isn't this is not a view about the dollar. We still want a strong dollar.

20:14This is just a view about the yen. And we're just expressing this in a way that makes it clear that this is a view about the yen. It also let him do like kind of surprising things like there was the rate check in euro yen, which caused a lot of confusion in the market. But at the end of the day, the you know, we don't know the volume. We don't know if he actually did the five to 10. Maybe we'll see in a week or so. But the vast bulk of the intervention was from Japan's Ministry of Finance and it was in dollar yen. So fundamentally, this was a dollar yen intervention,

20:47not a euro yen intervention. Brad, you mentioned that if you were to go by something like the Big Mac index, the dollar yen or the yen is at historically weak levels. And of course, there's all kinds of attempts to measure like what like fair value of a currency is. Right. So you mentioned the Big Mac index and then there's like, I don't know, beer models and rear models and exchange rate differential models and GDP differential models. Do any of them work anymore? Are any of them

21:19consistently either predictive or useful or like what is the state of all of these sort of classical approaches to determining fair value of any given currency? The Big Mac index is a version of purchasing power parity that sort of prices, broadly speaking, should be the same if you're at comparable levels of development. Recently, particularly vis-a-vis Asia, the market pressure, the financial pressures have pulled currencies further away from their purchasing power parity levels.

21:56So that hasn't, as a predictive variable, that hasn't worked. As an analytical tool, I still think it's valuable. You know, a behavioral equilibrium exchange rate model fundamentally looks at policy settings today and says, you know, what's the impact of the policy settings? And then it says, we don't know what the equilibrium value of the currency is, but we know what it is, where it has been in the past. So given the policies and given the past, is the currency strong or weak? All the Asian currencies kind of score is weak on this because they are fundamentally incredibly weak. I mean,

22:32we haven't talked about China, but China has a big and growing trade surplus. Use a current account based model. You'll find that China's currency is undervalued. Certainly Korea's currency is undervalued on a current account based model. All these show is undervalued on behavioral exchange rate based models. So basically, like what we know is that financial flows have pulled currencies quite far away from any of the more fundamental or purchasing power based measures.

23:00So I want to go back to the idea of avoiding additional pressure on the U.S. Treasury market.

U.S. Treasury Market Pressure

23:07And a big component of this seems to be use of this Fed facility that I mentioned earlier. It's called the Foreign and International Monetary Authorities Repo Facility, very catchy, or FEMA. And it basically allows foreign central banks to use their treasuries as collateral to get dollars. But from what I understand, and I should say this facility, I think, came about during 2020, during the pandemic with the big treasury market route. From what I understand, it charges above market rates for central

23:41banks. And so one of the criticisms I've seen lately, or maybe concerns, is that the FEMA repo facility is ultimately going to be uneconomical for central banks. Like, why would they want to use it if they could just repo treasuries at cheaper market rates? And then secondly, the facility is also capped at something like $60 billion. So if you need to intervene again, someone's going to have to raise that limit. What are the sort of pros and cons of using this particular facility in this way?

24:13You're a fan, right? I'm a fan. I publicly, I privately pushed for it back when I was at the Treasury. I publicly pushed for it in 2020. I think it is a useful tool. The basic idea is that central banks have a lot of really good collateral. And if they need cash, they don't actually have to go and sell the treasuries into the cash bond market. They can just repo them at the Fed, get dollars, and then intervene that way. And it's zero risk to the Fed. And the Fed can always offset any monetary impact with its domestic

24:49operations. So there's no necessary monetary impact. It's just a way to allow, in times of stress or times of pressure, a central bank to avoid having to immediately sell treasuries. And remember that in 2020, we kind of got into a downward spiral in the Treasury market where central bank sales were sort of begetting private sales and the long bonds was really selling off and the Fed had to come in and do a lot of direct bond purchases. So, you know, it sort of makes sense to have this additional

25:23tool in the toolkit. You know, why do it with the Fed rather than with it? Well, first of all, I guess, you know, the Fed, you know, not in this case, is a little quieter as a counterparty. I mean, it is disclosed, but with a weak lag. It is, in theory, you know, if you get rid of the cap, it's unlimited in the quantities. And then the premium is there. It's not huge. But, you know, you can debate where it is not. It was not meant to be used as a substitute for repo in ordinary

25:56conditions. So it does have a premium. I think you can argue that right now, if you're the Ministry of Finance and you got a legacy five-year bond with a pretty high coupon, you're better off using FEMA repo than dumping it in the market. You're going to be able to cover the cost of FEMA repo out of the coupon on the bond. And if obviously if you sell the bond, you're never going to get that bond at that yield back. It gives the, you know, the Ministry of Finance a bit of flexibility. At a minimum, it means it can intervene and then sell treasuries with a lag.

26:31It doesn't have to sort of immediately sell. Now, Japan does have a cash buffer. When they've intervened in the past, for whatever reason, they haven't used their cash buffer. They've pretty directly sold treasuries. So I think, you know, it just gives another tool to the Ministry of Finance and gives the Ministry of Finance more options about how it generates the dollars that it's selling.

27:12This is the Bloomberg Tech Minute brought to you by ChatGPT. Now with ChatGPT work. I'm Carol Masser. Globetrotters hunting for airfare bargains are in for a rude awakening as the days of stumbling across a cheap seat on a popular flight could soon disappear. Bloomberg's Juan Ha reports that airlines from Delta to Virgin Atlantic are adopting artificial intelligence to change seat prices more quickly by weighing dozens of variables in real time, helping capture more revenue while shrinking

27:43pricing gaps that once allowed travelers to find bargain fares. Machine learning models can more accurately forecast demand by analyzing historical booking patterns, seat inventory, and seasonal trends, while also continuously tracking competitors' fares and capacity changes to update prices in near real time. The technology could lead to higher fares on busy routes as airlines pack flights closer to capacity, but may also result in lower fares on off-peak and lower demand routes. That's the Bloomberg Tech Minute brought to you by ChatGPT. Put ChatGPT to work on your most ambitious ideas and

28:18projects. Get started at ChatGPT.com today by selecting Work Mode, available on Plus and Pro Plans. Fill your tank and fill yourself with new experiences. With old friends, new ones, and the next generation ready to ride. Get to living with Harley-Davidson motorcycles. When the day is finally yours and all you see is open road, you remember why you want to ride. Visit White Lightning Harley-Davidson and see what freedom looks like. Tap the screen now and start your ride at h-d.com slash ride. Harley-Davidson

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30:03you know what, $150, $150 end of the dollar, that is our line in the sand. We're not going to let it weaken beyond that. And then you might not even have to spend a penny because, you know, no one's going to, people might not want to test it. And you just say, we have unlimited firepower because we're spending our own currency. We're just going to cap it there. Yeah, there's something that limits Secretary Besant from doing that, which is that he doesn't control the Fed's balance sheet. Secretary Besant just has the ESF. Now, the ESF has ballpark $20 billion in FX, ballpark $20 billion in

30:38liquid dollar cash, and then the special drawing rights, which it has like $160, $170 billion of a lot. But not unlimited. And using the special drawing rights is kind of even more out there than using FEMA repo, you know, it's sort of. So, you know, the Treasury on its own probably doesn't have the firepower. Now, you can argue that between the Treasury, the MOF, if Japan could, through some magic, change some of the pension funds, operating guidance, so that it started hedging its $950 billion

31:16portfolio, there's more than enough firepower there collectively to set a target, sort of a yield curve control type target, $150, probably be more like $160 now, and thereby implement that. So, you know, whatever it takes, this is going to stay below $150 or $160. The world does change. Oil shocks happen, inflation shocks, the Fed may be raising rates, people think the Bank of Japan is likely now to raise rates. So I think the risk on that is that you get locked into defending a level,

31:51and then the world changes. But, you know, conceptually, you could try to do that. I think what the Ministry of Finance is trying to do is reestablish fear in the market around $160. Okay. I mean, that used to be kind of a level where, you know, if you were going to go short the yen, you'd be a little nervous that the MOF might come in and whack you. But then when they didn't defend $160. It's like the MOF are whacking you, right? I mean, look, the weak side of the yen has been defined by the Ministry of Finance for the past several

32:21years. I mean, that's a conventional view in the market, given that the interest rate differential favors the dollar. By the way, we should discuss fiscal policy, because U.S. fiscal policy is way worse than Japanese fiscal policy. So I don't buy this fiscal fears or whatever. It is rate differentials. But the rate differential has favored the dollar. And the limit for the past, I would say, three years on how weak the yen gets has been set by the MOF. And when the MOF didn't intervene at $160, and then the last time it intervened at $162,

32:56you know, people thought, well, maybe they're going to allow further moves. And we'll make a bet that the MOF is going to tolerate a weaker yen, given that Ueda has been slow to raise rates. And so I think this is fundamentally about saying, we're going to defend $160. There's a lot of risk around $160. Be careful if you want to just go short yen when you're close to that level, which is a softer version of the, we're just going to defend $150 to kingdom come. All right. Well, on that note, perhaps the biggest question other than, you know,

33:29why did all of this happen is, is it going to work? And I mentioned earlier, the yen is trading at like $155, $156 to the dollar. That's better than where it was before this intervention, but it is starting to weaken ever so slightly again. And on that note, Adam Posen had a pretty funny quote in the Financial Times. Did you see this joke? Oh, I didn't see it, no. So basically saying, verbatim quote, the irony of the guy working for Soros and Stanley Druckenmiller,

34:02who broke the Bank of England back in 92, pretending that you can do FX intervention alone and lastingly defend a currency is just amazing. So again, this idea of like, how much firepower does the U.S. actually have? Does this need to be more coordinated? Do you think this is enough? I think it will be enough if the Bank of Japan is going to raise rates and maybe raise rates several times. I think the only reason why it wouldn't be enough if the Bank of Japan is going to raise

34:35rates. And look, I think if the Bank of Japan doesn't raise rates in September, this will be tested clearly. I mean, that would signal there's not full commitment inside Japan to defending the currency. And even in the classic sense, the monetary and fiscal authorities have different views. But if the Bank of Japan does raise rates, the other side of the currency pair is the dollar. And so it depends a little bit on what Warsh does. But if the Bank of Japan is raising rates faster than the Fed from this point on, I actually do think this will work. You know,

35:09Adam never believes currency intervention works, by the way. So it's not at all a surprise that he has this view. And I think he should reflect a little bit on why the yen and why currency traders are nervous around key levels. Because in the short run, most market people I talk to say intervention can work over a reasonably short period of time. And it can work over a longer period of time. If the currency is overshot, I would say the yen has overshot. If the fundamentals

35:41are evolving in a way that is going to be eventually favorable to that currency, you can make that argument with Japan. You know, oil prices, if you know, that depends on what happens in the straits and with Iran. But oil prices are not at their highs. That helps Japan. The BOJ seems likely to raise rates in September. Certainly, the BOJ could be on a path that brings short-term rates up to closer to, you know, inflation. So on a path that leads it to two over time. That should support

36:12the yen if the Fed's stable. Long-term Japanese rates have converged with long-term U.S. rates. Yeah. So the long-run interest rate differential is now actually at odds with the yen. It's given this rate differential, the yen should be stronger. The current account is actually quite solid, 5% of GDP. Japan's getting ever more money on the same level of its U.S. portfolio because U.S. rates are now higher than they were when Japan bought its original bonds. So that's not really at risk.

36:45And, you know, the key thing is that you got to change expectations. And the expectations have been that the yen is going to stay weak and maybe get weaker. So in that context, this huge foreign portfolio of Japanese institutional investors is generally becoming less hedged over time. You change that. And I think you change the dynamics. And where I probably differ a bit from people like Adam or more like the conventional international macroeconomics school is that, you know, I do think

37:15Japan is unique in a couple of ways. One way it has been unique is that, you know, the companies that have this massive foreign presence make enormous profits abroad. Those profits translate into enormous yen profits, but they don't actually bring the dollars, euros, yuan that they earn abroad back home. They tend to reinvest it. So that doesn't generate a flow. And then the irony is a lot of the non-FDI foreign assets are held by the government. You know, the bulk of the unhedged portfolio

37:49is actually in the hands of the MOF and the GPIF, the pension fund. And they typically don't repatriate. So, you know, they're generating, you know, the reserves were generating 35 to 40 billion in interest a year. But in normal times, that just was compounding abroad. The GPIF gets dividends, it gets interest. It doesn't repatriate that. Now there's some portfolio rebalancing, there's some additional complexities. I won't go into that. But in the normal course of action, all this interest

38:20income that goes to the government, which is well above a, you know, it's well above a percentage point of GDP is heading towards two percentage points of GDP doesn't hit the FX market. So in a sense, I think in order to equilibrate flows, you're going to need to see a way to, you know, have the winner of a weekend, which in a financial sense has been the government of Japan, take some of its winnings and bring them back home. And so in that sense, I tend to view this a little more favorably. I think this is part of the conditions needed to set a floor under the yen over time,

38:57together with the Bank of Japan. So to me, you got to have the Bank of Japan, and then you have to have the flow dynamics. And the interesting thing about Japan is that the government is by far the biggest actor on the flow dynamics. It has the biggest foreign asset position, and it has the biggest capital gains from yen weakness. By the way, for those who don't know the numbers, you know, as you mentioned, the long end of the curves in the U.S. and Japan converged somewhat. But, you know, the Fed's current rates is between three and a half and three and a quarter. Bank of Japan is still

39:28one percent. So that's really where this gap persists. We'll see, as you mentioned, if the BOJ closes it. Before we wrap, let's talk about fiscal policy for a moment. Because, you know,

Fiscal Policy Discussion

39:38going back in 2016, the yield on the Japanese 30-year was like 0.05, like something, like truly nothing. And now it's like around four percent. There are these, because the debt to GDP is so high, there are these fears that if rates rise across the curve, a significant share of government expenditures are in the form of interest payments. That furthers the inflation problem. Then you have what people call fiscal dominance. It spirals out of control. The central bank can't fix it. That is

40:09sort of like the classical version of why some people think that you should short the yen because it will one day be worth confetti or something like that. What is wrong with the theory that this is the the piper being paid? Is that a phrase? The piper being paid from years of overly loose fiscal policy? Well, I like I like the way you phrase it as years of overly loose fiscal policy, because you didn't say today's fiscal policy is overly loose. Right. What has changed, certainly compared to

40:402014, even compared to 2016, is that the primary balance, so excluding interest, government revenues relative to expenditure, has is now in balance. It's now flat. There's no primary deficit. That makes Japan one of the better G7 economies, certainly better than the United States, certainly better than UK, certainly better than France. I think better than Germany now, too. I mean, I think if you count the defense spending. So Japan no longer has a big primary deficit. It's primary is actually trending

41:14towards a primary surplus. The moth loves to play games where if you don't do a stimulus, you actually tighten because the way they structure the budget, they sort of force the government to go out and argue for a stimulus to offset what they mechanically have baked in as a tightening, which is why we ended up, you know, Japan has outperformed the IMF's forecast this year. It's really, you know, at a primary balance rather than in a modest 1% primary deficit. And so, you know, you're not in a position where

41:45things are on the edge of spiraling out of control. Now, it is certainly true that the interest burden will go up if the Bank of Japan hikes rates. And it will actually go up even if the Bank of Japan doesn't hike rates because there's an awful lot of bonds that were issued in the past at very, very low rates. They will mature. They'll have to be refinanced. With higher inflation, higher nominal growth, the debt dynamics don't go crazy because you have higher nominal rates, but your nominal rates

42:17aren't wildly out of line with nominal growth. Real rates are probably still below or equal to real growth and your primaries in an okay position. The other weird thing about Japan is that the government of Japan holds on its balance sheet. So the Ministry of Finance is part of the government. It holds the reserves. The reserves in Japan make money. They are in dollars with this higher interest rate compared to the short-term cost of funding in yen. The GPIF, the government pension fund,

42:48makes money. It has higher yielding foreign assets. So the net interest payments on Japan are actually, for at times, they've been close to zero. Now, that's a function in part of the backward-looking low rates, but it's also a function of the fact that Japan's government has this massive foreign asset position. Long-winded way of saying you should worry if nominal rates go way up and

43:21inflation doesn't go up. But if nominal rates converge to levels that are consistent with inflation and if the primary stays where it is, Japan's debt dynamics are actually not bad. The net debt levels have been falling. In five years without much change, net debt in the U.S. will surpass or be close to that of Japan. And remember, when you're short in the yen and to go long the dollar, you're going long U.S. fiscal. And I would argue, if you look at the full range of variables, not gross debt,

43:54but the dynamic path of net debt, the primary, absolutely, the fiscal balance, one percent of GDP in last year. And that's not the U.S. We're at six. We were five-ish last year, but we're not now at six. We're heading up. That's before the defense spending. I think what has gotten people nervous is Takeichi doesn't want, at a minimum, to get a bigger surplus. She's pushing back against the MOF's plans. She may want to go back to a modest primary. And she expresses this in a way that generates a lot of angst. But the underlying fiscal performance of Japan, stack up Japan using the IMF's fiscal monitor

44:30variables against the U.S., and then compare that to the rhetoric that is tossed around. And I would say there's a very big gap. All right. Well, on that note, Brad, thank you so much for coming back on the show. Really appreciate it. Oh, thanks. Thanks for letting me explain my, this is one area where I'm not the most conventional. Yeah, it was great. That was excellent. And just remember, this last thing, just always remember, Japan is selling dollars it bought between 80 and 100, depending

45:02on when they bought them, at somewhere around 160. This, at the worst, you can say, this operation, it reduces gross debt in a really big way. Awesome. That was excellent. Thanks, Brad. Hopefully talk to you soon, but not too soon. Joe, always good to catch up with Brad and get his perspective. Yeah. A few things stood out from

45:38that conversation. So one, it is kind of crazy how long the memory of the lost decade is lingering here. And we see this time and time again, both in economics and the business world, which is like, people just remember the past cycle, right? And it influences their current behavior. Understandably so, in the case of Japan. The other thing that stood out to me is this idea of, okay, the Treasury has done this sort of creative intervention in order to ease pressure on long-term treasuries. But there seems to be a tension there with what the Fed's doing at the moment, right?

46:14Yes. Yes. So Warsh is like, oh, you know, like, markets. You have more of an activist say in where Treasury yields are going. It shouldn't all be about the central bank. And so we've seen longer-term Treasury yields go up. So now you have this weird situation where, like, Treasury clearly wants them to come down, whereas the Fed is kind of like, do your own thing. Totally. There's lots of in there. One of the first things that Brad said that I thought was interesting, and it sort of speaks to your point about the lost decade, is he's like, oh, the BOJ

46:45has done all this work to get inflation back to 2%. And in my mind, I was thinking like, oh, yeah, right? Like, when he says all this work, they're trying to get inflation back down. But then I remember that in Japan, it's the other direction. And so, like, you know, for years, the story was like, no inflation, no inflation. Maybe they just want to let it run hot a little while to fully put the last really multiple decades of, like, no inflation truly in the past. I also think it is interesting and probably no one really talks about it, the idea that Japan's fiscal position, at least by

47:17certain objective measures, clearly improving, clearly looking better than the trajectory of the U.S. these days, at least if you're looking at a primary deficit. And then to his point, you know, there's numerous, you know, the classical metrics that economists use to measure the valuation of a currency. We know none of them are that great as metrics go, but they all point to the end, in fact, being undervalued. Yeah. All right. I think we should end it there before I make a terrible turning Japanese treasury market cliche.

47:48Oh, you know what? I thought of a good pun, but someone had already used it. Oh, what was it? Keep calm and carry in. Yeah. All right. No, you know, it's like, it actually has only been used a handful of times. Really? Yeah. I just looked it up. It's just a few random... You need to make those posters. I know. Stick them on the wall. If I had been the first, I would do it, but I was not. All right. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers,

48:21Carmen Rodriguez at Carmen, Armand, Dash O'Bennett at Dashbot, Kale Brooks at Kale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And for more Odd Lots content, go to Bloomberg.com slash Odd Lots or the daily newsletter and all of our episodes. And you can chat about all of these topics 24-7 in our Discord, discord.gg slash Odd Lots. And if you enjoy Odd Lots, if you like it when we shine the Brad Setzer bat signal, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely

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