Yen Decline May Force Liquidations and Shake Global Markets

U.S. Treasury Secretary Scott Bessent issued an unusual warning for an official of his stature: disorderly fluctuations in the Japanese yen could trigger forced liquidations of positions on a global scale. The result, he said, would be a cascading effect capable of raising financing costs for American families and businesses.

The warning came in a letter dated August 27, published by Bessent on his social media in response to inquiries from Democratic Senator Elizabeth Warren regarding the rare joint currency intervention between Washington and Tokyo that took place on July 31. The episode reignites a central debate in the markets: to what extent is the yen's weakness a local problem or a systemic time bomb.

Japan is the world's fourth-largest economy and the largest external creditor on the planet. Japanese investors hold colossal volumes of U.S. Treasury securities, European debt, and global risk assets. When the yen depreciates abruptly, these investors face pressure to repatriate capital, which can mean massive sales of assets in other markets.

It was precisely this mechanism that nearly spiraled out of control in July when the yen hit a 40-year low near 164 per dollar. The Japanese currency weakened again towards 160 after the joint intervention, briefly breaking that threshold last Friday. The level of 160 yen per dollar is widely seen by traders as the threshold that increases the likelihood of new interventions, as we have detailed in our coverage of global markets.

For investors in Brazil, the scenario is not irrelevant. Forced liquidations in developed markets often generate risk aversion in emerging markets. Money flows out of riskier assets, the real depreciates, and the cost of capital rises. The episode in August 2024, when the yen carry trade partially unwound, caused stock markets worldwide to tumble within hours.

The carry trade is one of the oldest and most widespread operations in the foreign exchange market. The investor borrows in a currency with low interest rates (historically the yen, with rates near zero) and invests the funds in assets of currencies with higher interest rates, such as the U.S. dollar or the Brazilian real.

The problem arises when the yen appreciates suddenly. The investor who borrowed in yen sees their debt grow in dollar terms, forcing them to liquidate positions to cover the margin. This movement feeds back into itself: the more people sell, the more the market falls, and the more liquidations are triggered.

According to estimates from the Bank for International Settlements, the global volume of carry trade denominated in yen exceeds $4 trillion. Even a partial reversal of this amount is enough to cause serious disruptions, as we have analyzed in the context of global interest and exchange rate dynamics.

In the letter, Bessent detailed the mechanism used. The U.S. Treasury used foreign currency assets held in the Exchange Stabilization Fund (ESF) to buy yen in conjunction with the Bank of Japan. The ESF is an emergency reserve created in the 1930s, managed by the Treasury, with the specific mission of stabilizing foreign exchange and financial markets.

Bessent drew a direct parallel with Argentina, where the same fund was used to provide a $20 billion currency swap line aimed at stabilizing the peso during a moment of severe illiquidity. "The same principle was applied," wrote the secretary. "The best-managed crisis is the one that never happens."

Bessent's defense is significant because joint currency interventions between the U.S. and Japan are extremely rare. The last one before this occurred in 2011, after the earthquake and tsunami that devastated eastern Japan. The fact that Washington agreed to intervene now suggests that the level of concern about a disorderly scenario is genuine, not just rhetorical.

The scenario became more complex with recent statements from Federal Reserve Chair Kevin Warsh, which reignited expectations of a possible interest rate hike in the U.S. in the short term. Higher U.S. interest rates widen the interest rate differential between the U.S. and Japan, which pressures the yen downwards and makes the carry trade even more attractive, creating a cycle that ultimately raises systemic risk.

The Bank of Japan, for its part, faces a dilemma. Raising interest rates to defend the yen could harm the fragile domestic economic recovery and pressure the Japanese government bond market, the largest in the world. Keeping interest rates low, on the other hand, means accepting that the currency continues to depreciate, raising import costs and eroding the purchasing power of the Japanese.

What is at stake goes beyond a bilateral currency dispute. As we discussed in previous analyses on global monetary policy, Japanese capital flows are one of the main determinants of global liquidity. A sharp shift in these flows would have consequences for all asset classes, from U.S. Treasuries to cryptocurrencies.

Three indicators deserve attention. First, the level of the yen against the dollar. A sustained drop below 160 significantly increases the chance of new intervention. Second, the interest rate differential between the U.S. and Japan, which is the fundamental driver of the carry trade. Third, the capital flow data from the Japanese Ministry of Finance, which shows whether Japanese investors are selling or buying foreign assets.

Bessent's phrase, "the best-managed crisis is the one that never happens," carries an implicit message. Washington is willing to use extraordinary tools to prevent the yen's fragility from turning into a global credit event. It remains to be seen whether the willingness will be sufficient if the interest rate differential continues to widen.

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