By Mike Dolan

LONDON (Reuters) – If Japan’s government is thinking ahead, it may be looking to rein in its errant yen rather than prop it up.

A two-year cat-and-mouse game between speculators and Japanese authorities, involving growing bets against the yen on widening interest rate differentials with other G7 economies, ended this month with the cat licking its lips despite suffering from indigestion.

The yen’s fall to its lowest level in almost four decades, which played no tiny role in the departure of yet another Japanese prime minister this week, prompted months of warnings from the government and then periodic intervention by the Bank of Japan to buy yen.

But when the Bank of Japan finally raised interest rates again on July 31 and warned of more hikes, the carry-trade bubble burst and the currency reversed sharply, triggering a brief but jarring spike in volatility on stock markets in Tokyo and around the world.

Mission accomplished?

There is a group of people who believe it may work too well.

If we recall recent periods when the Bank of Japan bought or sold yen every two or three years to accelerate exchange rate movements, there is a high probability that the currency will quickly depreciate again.

None other than Nomura, Japan’s largest brokerage house, raised this outlook before last week’s crisis.

“We may need to start considering potential currency interventions by the MOF (Ministry of Finance) to limit the strength of the yen, not weaken it,” the macroeconomic research team told clients on Aug. 2, adding that this was not yet its “base case.”

“The history of interventions tells us that interventions to buy the yen have been followed by interventions to sell the yen, aimed at limiting excessive appreciation of the yen.”

THE TENDENCY TO SPACE

And until recently, at least 10 years ago, it was a routine pendulum swing.

The most celebrated episodes of currency intervention were the collective G5 and G7 expeditions in 1985 and 1987 – with the former Plaza Accord, which weakened the dollar, and two years later the Louvre Accord, which strengthened the dollar. The dollar/yen was at the center of these swings.

However, Japanese government interventions targeting the yen caused official purchases and sales of the yen to fluctuate between 150 and 75 yen per dollar every few years for two decades following the real estate crisis of the 1990s.

Extremely low interest rates in Japan since the crash and the resulting inflation and deflation of speculative carry trades paved the way for volatility and overshooting in both directions during this period.

The routine “ebb” was yen weakness, and the “flow” was exaggerated bounces in times of stress or volatility, when carry trades were broken up or Japanese investors fled repatriated overseas investments. And this was a key reason why the yen acted as a “sanctuary” during all the market shocks during this period – something that magnified the moves in the mix.

But the great financial crisis of 2007-08 was followed by a decade in which interest rates in virtually all Group of Seven countries approached zero, as in Japan – dampening the temptation of carry trades and allowing the yen’s relatively stable exchange rate to effectively sideline an overactive Bank of Japan currency office.

In fact, there was no confirmed intervention between the extraordinary 2011 earthquake and tsunami and 2022 – when post-pandemic interest rate increases and the invasion of Ukraine elsewhere drove Japan back to zero – restarting carry trades.

The wild swings of the past few weeks are evidence of the currency’s tendency to overvalue.

NORMALIZED INCOME GAPS?

Flash forward, and it’s not difficult to see where the yen’s burst of strength might come from. As U.S. and other G7 interest rates finally fall and carry trades clear, Japan could feel emboldened to continue “normalizing”—increasingly confident that the decades of deflation since 1990 are over.

While markets now believe Tokyo may be even more cautious about raising interest rates again for fear of a stock market shock like it did earlier this month, the latest GDP data could be encouraging, a novel prime minister is coming to town soon and the US Federal Reserve is likely to start cutting interest rates next month anyway.

Two-year Japanese core bond yields have fallen below 30 basis points from 15-year highs of nearly 50 basis points earlier this month. Given that, any suggestion of higher rates would warrant a significant revaluation.

However, the gap in profitability with the rest of the G7 countries has already narrowed.

Two-year spreads over U.S. Treasuries have fallen 1.1 percentage points in just three months, and the dollar/yen has responded to that change with only a three-month lag. It would take another 1.7 basis point squeeze in that spread to return to its 10-year average—and that could happen relatively quickly, if it comes from both sides.

Fears of Donald Trump’s sweeping trade tariff commitments if the Republican former U.S. president wins the Nov. 5 election could be another reason for Japan to hold off for a while. But Trump is no longer the favorite in either opinion polls or betting markets.

While another rate hike could prove to be partially ineffective if the yen’s strength hurts exporters and the Japanese economy as a whole, the flip side of currency strength is lower import prices that allow for higher real wage increases, which in turn could become the holy grail of domestic consumption growth.

But if the yen’s strength increases too much and too quickly, you can always intervene to composed it down.

The views expressed in this article are those of the author, a Reuters columnist.

(via Mike Dolan X: @reutersMikeD; Editing: Paul Simao)