Joint U.S. and Japanese currency intervention reveals eroding Dollar dominance

Last week, the U.S. intervened in the currency markets to support the Japanese yen. The way the U.S. executed the move reveals that the dollar’s reserve status isn’t what it used to be.

Typically, when the U.S. intervenes in currency markets, it buys a foreign currency using dollars. The sudden surge in demand for that currency strengthens it relative to other currencies. The downside is that the dollar sale weakens the U.S. currency.

For example, in a simple currency intervention, the U.S. buys yen with dollars. But last week was different. The Treasury Department took a new tack, buying yen with euros, thereby preserving dollar strength.

On the surface, it looks like the U.S. was willing to help Japan but was concerned with maintaining dollar strength. Notably, according to the Financial Times, the move "blindsided" the European Central Bank. U.S. officials didn't inform the ECB until after the operation.

In an op-ed published by the Financial Times, U.C. Berkeley economics professor Barry Eichengreen argued that the way the Treasury executed this currency intervention reveals a deeper concern.

“The message is that U.S. Treasury Secretary Scott Bessent & Co worried that selling dollar securities to prop up the yen would put additional strain on the long end of the US Treasury market.”

The sagging demand for U.S. Treasuries is a growing problem for U.S. policymakers. As bond demand drops, prices fall. Inversely, yields rise. This increases the federal government’s borrowing costs. With the U.S. already spending over $1 trillion per year in interest expense, Uncle Sam can’t afford to lend money at even higher rates. Policymakers must find a way to support Treasury demand.

Eichengreen said that selling euros rather than dollars was likely partly a function of "that's what the Treasury had on hand" in the currency stabilization fund; however, there is almost certainly more to the entire operation than that.

“It is also a way of not asking the market to swallow additional Treasuries sold to reduce dollar exposure, which would have aggravated an already delicate situation.”

The mechanics of currency intervention

When a country wants to strengthen its currency, it typically sells a foreign currency (often dollars) and then buys its own currency with the proceeds. In Japan’s case, it sold dollars to buy yen.

But what if the Japanese treasury doesn’t have enough dollars on hand?

It can sell dollar assets for dollars and then buy yen with the proceeds.

The transaction would look like this:

Japan sells U.S. Treasuries for dollars ~~> Japan uses the dollars to buy yen.

This creates a bad feedback loop.

1. The yen is weak
2. Japan decides to intervene and defend its currency
3. Japan needs dollars
4. Japan sells some of its U.S. Treasury holdings to raise dollars
5. U.S. Treasury prices fall (supply and demand – more Treasuries on the market pressure prices)
6. Long-term yields rise (Yields are inversely correlated with bond prices)
7. Higher U.S. yields incentivize investors to seek dollar assets
8. The dollar recovers, but the yen weakens again

The Japanese have been engaging in market intervention for several months. The country’s foreign currency reserves fell by $75.6 billion in May. According to Bloomberg, this broadly matched the scale of yen intervention that month. Fed custody data showed a decline in Japanese Treasury holdings consistent with this liquidation.

Now enter the U.S.

Bessent doesn’t want Japan to sell Treasuries, so it offers to step in. If the U.S. buys yen, it kills two birds with one stone. The yen gets a boost without increasing the supply of Treasuries in the open market and raising yields.

In effect, U.S. intervention reduces the amount of dollars Japan needs to raise by liquidating Treasuries.

The U.S. has a vested interest in maintaining stable currency markets. Intervention is typically reserved for “excess volatility.”

But the U.S. wasn’t just trying to help a friend. It was trying to keep a lid on its own problem – a tanking Treasury market even as the U.S. needs to borrow more to keep up with ever-increasing spending. 

The FIMA repo facility

In another move that signals Japan is willing to cooperate with the U.S. and prop up the Treasury market (or was coerced into cooperating), Japanese officials say they will use the Foreign and International Monetary Authorities (FIMA) facility to conduct future currency support operations.

In the early days of the pandemic, foreign institutions needed dollars and started selling Treasuries to raise cash. This created severe volatility and dysfunction in the Treasury market. In response, the Federal Reserve created FIMA in March 2020. This facility allows foreign monetary authorities to obtain dollars without selling Treasuries outright. Instead, the Fed loans them dollars, and the foreign government pledges Treasuries as collateral.

FIMA loans are very short-term – a maximum of seven days. However, loans can be rolled over.

Eichengreen said both the U.S. intervention and Japan’s willingness to use FIMA indicate “the dollar’s status as a reserve currency is not what it used to be.”

"Central banks are accustomed to holding foreign reserves in dollars because markets in U.S. Treasury securities are liquid. Central banks hold U.S. Treasuries because they can be freely bought and sold and used in interventions. But not now, at least not in unlimited quantities. Instead, we see the U.S. Treasury stepping in with euro sales as part of its contribution to the intervention, thus limiting the volume of dollar sales needed by the Japanese authorities."

Eichengreen said the bottom line is the U.S. is reluctant to see foreign central banks use dollar reserves due to the potential ramifications for its own financial markets.

“This is telling us that the dollar is not the attractive reserve currency it once was. When this message sinks in, other countries will redouble their search for more attractive, readily usable alternatives. Reserve diversification is apt to gather steam.”

The report put it even more bluntly:

“That strikes at the heart of dollar dominance, which is in part derived from the immense size and depth of the U.S. debt market.”

Central bank gold buying is part of the “reserve diversification” Eichengreen mentioned.

In a note, Capital Economics economist Kieran Tompkins said the move increases the appeal of holding assets like gold.

“The ability of central banks to conduct FX operations without triggering concerns from U.S. administrations about the impact on U.S. bond markets could provide fresh impetus to central banks' demand for gold.”