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The Japanese are Blinking


We walk in this morning to see that the yen has strengthened against the dollar significantly: the yen has broken the 105 level that the Ministry of Finance confidently declared as a "line in the sand". This has significant ramifications.

The Japanese government has bought $350 billion over the last twelve months at an average price of 113 in an effort to support the dollar. With the yen at 103.9, the Japanese have incurred $27 billion in currency losses, while earning around $5.5 billion in interest; they are now net losers in their U.S. bond position by around $21.5 billion (this is likely conservative given that they have also lost on the prices they paid for the bonds).

The Opposition Party has already questioned the Ministry of Finance's strategy of printing unlimited yen to buy dollars, and now has much more concern given that the strategy seems to be failing and the government seems to be throwing "good yen after bad dollars".

I can just see the cabinet arguing over this policy. It is clear that a stronger yen is causing economic problems (Sony recently announced layoffs of 10,000 people and sighted the strong yen as the reason), but the failing strategy of supporting the U.S. bond market now seems fraught with risk: the $21.5 billion net loss is a real economic loss.

The Japanese find themselves in a box. They have believed that coordination with the U.S. and keeping our rates artificially low (for they single handedly have done so) was in their best interest. By now they would have imagined that the U.S. economy would be strong enough to lift the dollar and increase imports from their country. They now have to be seriously questioning that strategy

The question now is how will the Japanese react to these losses?

Will they remain steadfast in the belief that the U.S. will pull them and the world out of the economic malaise and continue to buy our bonds at the expense of losing real capital?

Or will they blink?

All we have to do now is watch the U.S. bond market. The risk has now significantly increased that rates could rise and unlike Mr. Bernanke's claims, there will be nothing that the Fed could do about it.
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