by Sam Goldfarb, The Wall Street Journal, 10/24/2022
On Wednesday, interest-rate derivatives for the first time this year showed a better than 50% chance that the Fed would raise its benchmark federal-funds rate above 5% in 2023, though that percentage slipped to about 33% on Friday. The fed-funds rate is currently set at a range of 3% to 3.25% after starting the year near zero.
Investors also remain on edge about the potential for shrinking foreign demand for Treasurys, as global central banks aggressively raise interest rates, and in some cases, intervene in the foreign-exchange market to support their currencies…
Some investors have worried that Japan’s government is raising the dollars it needs to buy yen by selling some of its holdings in U.S. Treasurys. A possibly even larger fear is that the weakening yen will force the Bank of Japan to abandon its policy of holding down bond yields, creating a rush among Japanese financial institutions to sell large amounts of U.S. bonds in favor of their own government’s debt…[end quote]
Japan’s central bank has followed a Zero Interest Rate Policy for many years. During this time, Japanese pension funds, insurers and other institutional investors have made Japan the largest foreign buyers of Treasury debt, currently holding about $1.2 Trillion.
The yen has been falling against the USD since the start of 2021. From 0.0097 USD/yen (= 103 yen/USD) to the USD it has dropped to 0.0067 USD/yen (= 150 yen to the USD).
Japan is now intervening to support the yen. It may have to sell Treasuries to buy yen or it may finally allow interest rates to rise in Japan to support the yen. If interest rates rise in Japan, Japanese institutional investors may sell Treasuries to buy Japanese bonds. That could depress Treasury prices, raising interest rates.
The Federal Reserve is gradually allowing its bloated book of assets to decline as planned.
At the same time, the Federal Deficit for 2022 was $1.375 Trillion.
The bond and stock markets are exquisitely sensitive to daily hints from the Fed that maybe, maybe they will slow their planned rise in interest rates. Action from Japan that significantly impacts the laser focus on the Fed may upset the markets.
A Fed funds rate of 5% would be lower than inflation and thus stimulative unless inflation actually declines as the market expects. Even if inflation were to decline to 2.5% the real rate would not be highly restrictive, only the historical average.
But it’s the longer-term rates that impact economically important rates like mortgages. If Japan begins to act in a major way…there could be major negative consequences in the stock and bond markets.