Tracy Alloway: Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.

Joe Weisenthal: And I'm Joe Weisenthal.

Tracy Alloway: Joe, I think I know the answer to this question, but do you ever write to-do lists?

Joe Weisenthal: No.

Tracy Alloway: Yeah. [laughter] I figured.

Joe Weisenthal: No, I'm not. No.

Tracy Alloway: Uh well, I make a half-hearted attempt every day where it's like podcast recording one, podcast recording two, do the newsletter, reply to the following emails.

Joe Weisenthal: Yeah.

Tracy Alloway: But uh as of last week, I have seen the most epic to-do list ever.

Joe Weisenthal: Oh, yes. Yes.

Tracy Alloway: Presumably you saw this.

Joe Weisenthal: Yeah. Yeah, that I saw the uh the Scott Bessent to-do list, and it was basically like buy the yen, right?

Tracy Alloway: Right. So, US Treasury secretary

Joe Weisenthal: to-do list.

Tracy Alloway: Scott Bessent, there was a photo taken of him. Presumably he did this on purpose. One would hope, but he had a to-do list, and it basically just said buy Japanese yen, and he put in the JPY

Joe Weisenthal: Yeah. So, there's no no ambiguity.

Tracy Alloway: after 5 to 10 billion.

Tracy Alloway: Um yeah, so it was pretty clear that he was not referring to personal purchases in some vacation stuff.

Joe Weisenthal: the only thing on the Treasury secretary's to-do list, he he's not that busy, right?

Tracy Alloway: Um he's not, but he presumably is fairly busy. We know that the yen had been weakening dramatically. We know that there's been a recent sharp strengthening. There's always talk of a yen intervention here and there. I don't really understand fully why the yen is so weak, why the US feels compelled that it's important to get involved in that market, etc. I have many questions.

Tracy Alloway: Yeah, so the US did intervene um together with Japan in the yen to stop it from weakening, and what's really interesting about all of this? I mean, we love big foreign currency stories anyway, but what's interesting is this was kind of a new type of intervention. So, the US actually sold euros, which was very

Joe Weisenthal: Yeah. No, it's pretty wild. I mean, for so long, for like the first half of our careers, the story was like strengthening and strengthening yen, low yield currency, and everyone was like, the Bank of Japan, they've done all this work to try to get inflation up to 2%, but it's just this deflationary trap. Now, it's the exact opposite, and it's like the yen is weakening, weakening, weakening, and it seems like everyone wants it to stop, and it's creating all these weird dynamics.

Tracy Alloway: Absolutely. I have many questions. All right. So, whenever we have big questions about capital flows or FX moves, we shine our our Brad Setser bat signal into the sky, and he magically appears on the podcast. So, we do in fact have the perfect guest. We are speaking once again with Brad Setser, senior fellow at the Council on Foreign Relations. So, Brad, thank you so much for coming back on Odd Lots.

Brad Setser: Well, it's always fun.

Tracy Alloway: Maybe, just to begin with, let me ask the obvious question. If your currency is weakening to the degree that you think an intervention is necessary, why doesn't the BOJ, the central bank of Japan, just raise interest rates? Wouldn't that solve the problem right away?

Brad Setser: That is a very obvious question. Um for whatever reason, the Bank of Japan has been very slow to raise rates. So, the short-term policy rate is about one It is 1%. Inflation's coming down, but it's still running around 2.5%, so interest rates are negative in real terms. And Japan's got a big debt load, right?

Joe Weisenthal: [snorts]

Brad Setser: And, if you pushed up short-term rates, that would uh push up the the fiscal deficit and interest costs too much. I think that's a little overstated, but that is certainly one of the concerns. And then there's a deep-seated belief in Japan that inflation is not truly anchored yet, and that they need to be very, very careful about tightening policy too quickly because they don't want to fall back into the deflationary trap of the last 20 or 30 years.

Joe Weisenthal: I want to ask about why the yen has been so weak in the first place. But, I actually before that, maybe we zoom out bigger, because like weakness in East Asian currencies in general, right? Like it's not just the yen. The won has been weak. The New Taiwan dollar has been weak. The renminbi has been weak. But then, at the same time, we have these massive trade surpluses in East Asia, right? So, how do we reconcile this idea that these countries are exporting like crazy, they're running these huge surpluses, and yet their currencies are weakening?

Brad Setser: Well, look, you're right. Like the global trade surplus is now all in East Asia. The chip electric, you know, basically San Francisco decided to spend a lot of money on kit that is made in Taiwan, Korea, and Japan. And that has generated a huge terms of trade boom for those countries. Usually, when you have a terms of trade boom, your currency appreciates. But the opposite is happening. And the reason is capital outflows.

Joe Weisenthal: Okay.

Brad Setser: And like, you know, Korea's current account surplus is going to go from 100 billion in change to somewhere between 3 and 400 billion. Massive. You know, Taiwan's is probably going to double. And you know, it was big to begin with. So, we're doubling means going from like 15 to 25 to 30% of GDP. These are insane numbers. Uh with Taiwan, it's a bit different. Uh the the central bank doesn't want its currency to to strengthen. It has engineered a weakening of the Taiwan dollar compared to last year by reversing prudential regulations, basically letting the lifers unhedge their foreign assets. And then with Taiwan in particular, it's almost one company, TSMC.

Joe Weisenthal: Okay. And you can kind of lean on that company to tell it when it converts and when it doesn't. Bloomberg actually did one of the best stories I've ever seen about the Central Bank of China Taipei and how it is managing Taiwan's dollar without actually using its balance sheet. Korea's different. Korea has been strange. It's been this story where the better the news is for Korea, the more of the Korean stock market goes up, the more foreign holders of Korean stocks have to sell cuz they're hitting concentration limits. And that has created a weird situation where good news for the equities for Korea's equities, so you know, Hynix and Samsung, was leading to an outward flow and producing record weakness in the Korean won. That is layered on to outflows from the pension system. That is layered on to this whole story about, you know, Korean day traders used to do buy leveraged US uh ETF single stock ETFs and then Korea let them buy leveraged single stock Korean ETFs and that didn't turn out to be a great idea, but you know, it's sort of we end up with a world where you have this enormous positive terms of trade shock, enormous, that is producing record weakness. And that's in the it's in that context where we can think about the yen as being another of these country currencies that is, you know, kind of fundamentally okay. Japan has a current account surplus of 5% of GDP. It's investment income, it's not trade. Uh its trade accounts would be improving but for oil thanks to the AI stuff. Uh it's got one of the biggest foreign asset portfolios in the world. The government of Japan has, you know, still probably close to 1.2 trillion in reserves. That's a big number. And it has 900 billion plus in the government pension fund foreign assets. That's a big number. GDP is now down to 4 trillion. So you You the government is sitting on a foreign asset position of close to 50% of its GDP. The weakness was it has been throughout Asia

Tracy Alloway: [snorts]

Brad Setser: a bit counterintuitive, but for slightly different reasons. And with Japan, you obviously have the very low rates story as a central part of it. [music]

Tracy Alloway: [music] [music]

Tracy Alloway: So, when I hear the words currency intervention, I often associate that with currency speculation, right? And you hear central banks will come out and say like, "Oh, stern words to the speculators. You better watch out." and that sort of thing. With Japan, do we have indication of how much of this is actually speculation versus to your point earlier like actual outward investment?

Brad Setser: Like, there's a bit of speculation around the yen. Uh, you know, there's not a clean measure of the speculative flow, but like, you know, look, the yen was uh the one of the lowest yielding currencies. So, you it was a typical funding currency. I don't think the carry trade was on an enormous scale, but there was certainly uh hedge funds, others who more or less thought that the Ministry of Finance uh was going to allow the yen to weaken beyond what it had weakened before. And since, you know, the yen shorting the yen is positive carry. There's a higher yield on dollars than on on yen. As long as you're it's stable, you make a little bit of money, and if the yen depreciates, you make a lot more money. So, there was a bit of speculative betting on it. Not a ton, I would say. And then you have weird hedging dynamics. So, there's a little bit of a head dynamic where when the Nikkei goes up, foreigners holding the Nikkei need a hedge a bit more cuz some do partially hedge. When the Nasdaq goes up, the GPIF doesn't hedge, so it doesn't generate an offsetting hedging flow. And then despite all the hedge America stories from last year, in Japan, the key fixed income hedged investors seem to have gone a little bit less hedged. The life or hedge ratio has come down. So, you don't So, a lot of it is not quite your classic speculative flows, although there's a bit of that. A lot of this is hedging flows amongst real money investors. So, that does add a little bit of a different dynamic. But, I I I don't discount the fact that a bunch of uh investors, including a bunch of hedge funds, were basically making a bet that the yen would go to 170 because you waited it was behind the curve.

Tracy Alloway: So, let's talk about it from the US perspective. What is the reason that the weakening of the yen is something that would or should concern the Treasury Department?

Brad Setser: Well, I think the the classic concern, which hasn't been the concern that Secretary Mnuchin has articulated, is that extreme weakness in East Asian currencies gives East Asia a trade edge over American producers. I mean, classically, a weak yen is bad for Detroit. A weak Korean won is bad for Detroit. It's really uh you know, the traded goods pressure, most classically through the automotive sector, that has been the traditional driver of this. And to be clear, we are like fif you know, the won't come back a bit, but 1,500 is a crisis level of the won, and Korea's not in a crisis. 160 is an insanely weak yen on any Big Mac index. It pushes the yen below an in inflation-adjusted terms where it was it in the 1970s. We're back to the 1960s. These are extreme undervaluation in my view. And so in that sense the classic concern would be that this gives all these guys a huge edge over American

Tracy Alloway: Right.

Brad Setser: manufacturers. That hasn't been what Bentsen has emphasized. He's emphasized, "Well, the weak yen is putting pressure on the yuan is adding to this generalized malaise bizareness uh where good news is bad news for a lot of Asian currencies. And then there's a sense that this could create pressure on the Treasury market. Now, to be clear, if the yen just falls, that makes the value of Japanese investments in Treasuries higher. So [snorts] the the impact on the Treasury market would come if the Japanese resisted that, used their reserves, and the excessive use of their reserves or the use of their reserves started to to put pressure on the Treasury market cuz they have to fund they would fund it by selling Treasuries. So I think part of Bentsen's theory of the case is that by joining with the Japanese, first of all, you know, we're we're supporting the yen from an incredibly weak level. It's arguably overshot. It has decoupled from 5-year 10-year rate differentials for the past several months, past year even. And by helping the Japanese, we're helping a friend. That's what the president says. And we can jointly intervene in a way that reduces the possible pressure on the Treasury market. That would be I think the explanation I would give, but I you know, Bentsen hasn't been He's more I mean, the president said it was to help a friend. Uh Bentsen has said it's to avoid destabilization throughout the Asian currency complex.

Tracy Alloway: Why did they do it in euros? Or why did the US do it in euros? They sold euros.

Brad Setser: I mean, you know, some of it is just Secretary Best and being a former currency trader or wanting to have presumably a bit of fun. Um Uh you know,

Tracy Alloway: Just getting creative.

Brad Setser: euros, we can use euros, we have a few more dollars, but only a few more dollars. I mean, you can debate, I mean, this was clearly an intervention, but you know, when you shift from holding euros to holding yen, you are doing a euro yen transaction. And it sort of allows you to say, "We still want a strong dollar. This is just a view about the yen, and we're just expressing this in a way that makes it clear that this is a view about the yen." It also let him dodge the charge that he was abandoning the strong dollar policy.

Tracy Alloway: Brad, you mentioned that if you were to go by something like the Big Mac Index, the dollar yen or the yen is at historically weak levels. And of course, there's all kinds of attribution of this to Bank of Japan's policies.

Brad Setser: The Big Mac Index is a version of purchasing power parity that sort of prices, broadly speaking, should be the same if you're at comparable levels of development. Uh, recently, a Big Mac in Tokyo was half the price of a Big Mac in the US. That is an extreme deviation from purchasing power parity. Under normal conditions, you would expect some adjustment, but the carry trade was preventing that.

Joe Weisenthal: So, I want to go back to the idea of, um, avoiding additional pressure on the US Treasury market. And a big component of this seems to be use of this Fed facility that I mentioned earlier, the FIMA repo facility.

Brad Setser: I'm a fan. I publicly I privately pushed for it back when I was at the Treasury. I publicly pushed for it in 2020. Um I think it is a useful tool. Uh the basic idea is that central banks can pledge their Treasuries to the Fed and get cash dollars, rather than selling those Treasuries into the secondary market.

Tracy Alloway: [music] [music]

Tracy Alloway: Is there anything stopping Secretary Bessant from saying, "You know what? $150 150 yen to the dollar, that is our line in the sand. We're not going to let it weaken beyond that."

Brad Setser: Yeah, there is something that limits Secretary Bessant from doing that, which is that he doesn't control the Fed's balance sheet.

Tracy Alloway: Okay, right.

Brad Setser: Uh Secretary Bessant just has the ESF. Now, the ESF has ballpark 20 billion in FX, ballpark 20 billion in like liquid dollar cash, and then the special drawing rights, which it can convert, but it is not a huge fund relative to the trillions traded in FX markets.

Joe Weisenthal: you, right?

Brad Setser: I mean look, the the weak side of of the yen has been defined by the Ministry of Finance for the past several years. I mean that's that's a conventional view in the market.

Joe Weisenthal: All right. Well, on that note, perhaps the biggest question other than, you know, why did all of this happen is is it going to work? And I mentioned earlier the yen is trading at...

Brad Setser: No.

Joe Weisenthal: So, basically saying verbatim quote, "The irony of the guy working for Soros and Stanley Druckenmiller who broke the Bank of England back in '92 pretending that you can do FX interventions is rich."

Brad Setser: I think it will be enough if the Bank of Japan is going to raise rates and maybe raise rates several times. Uh I think the only reason why it wouldn't be enough if the Bank of Japan stays on hold.

Tracy Alloway: [laughter]

Brad Setser: Um so, it's not at all a surprise uh that he has this view. Uh and I I think he should reflect a little bit on why the yen and why currency traders are nervous around key levels because the Ministry of Finance has real bullets.

Tracy Alloway: [snorts]

Brad Setser: take some of its winnings and bring them back home. And so to in that sense, I tend to view this a little more favorably. I think this is part of the conditions needed to set a floor under the yen.

Joe Weisenthal: By the way, for those who don't know the numbers, you know, as you mentioned, the long end of the curves in the US and Japan uh converge somewhat, but you know, the Fed's current policy rate is still way above the BOJ's.

Brad Setser: Well, I like I like the way you phrased it as years of overly loose fiscal policy because you didn't say today's fiscal policy is overly loose.

Joe Weisenthal: Right.

Brad Setser: Um what has changed, certainly compared to 2014, even compared to 2016, is that the primary balance, so excluding interest, government revenues relative to expenditure, has is now only negative 1% of GDP. In the US, we are at six. We were at five-ish last year, and now we are heading up. That is before the defense spending expansion.

Tracy Alloway: [snorts]

Brad Setser: The other weird thing about Japan is that the government of Japan holds on its balance sheet. So, the Ministry of Finance is part of the government. It holds the reserves. The reserves in Japan make money. They are in dollars with this higher interest rate compared to the short-term cost of funding in yen. The GPIF, the government pension fund, makes money. It has higher yielding foreign assets. So, the net interest payments on Japan are actually for times they've been close to zero. Now, that's, you know, a function in part of the backward-looking low rates, but it's also a function of the fact that Japan's government has this massive foreign asset position. Long-winded way of saying there is wor- you should worry if nominal rates go way up and inflation doesn't go up. But if nominal rates converge to levels that are consistent with inflation. And if the primary stays where it is, Japan's debt dynamics are actually not bad. The net debt levels have been falling. In 5 years without much change, net debt in the US will surpass or be close to that of Japan. And remember when you're short in the yen and to go long the dollar, you're going long US fiscal. And I would argue if you look at the full range of variables, not gross debt, but the dynamic path of net debt, the primary absolutely, the fiscal balance. 1% of GDP in last year. And that's not the US. We're at six. We were five-ish last year, but we're not Now we're at six. We're heading up. That's before the defense spending. I think what has gotten people nervous is Takaichi doesn't want at a minimum to get a bigger surplus. She's pushing back against the MOF's plans. She may want to go back to a modest primary, and she expresses this in a way that generates a lot of angst. But the underlying fiscal performance of Japan Stack up Japan using the IMF's fiscal monitor variables against the US.

Tracy Alloway: [snorts]

Brad Setser: And then compare that to the rhetoric that is uh tossed around. And I would say there's a very big gap.

Joe Weisenthal: Mhm.

Tracy Alloway: All right. Well, on that note, Brad, thank you so much for coming back on the show. Really appreciate it.

Brad Setser: Oh, thanks. Thanks for letting me explain my uh This is one area where I'm not the most conventional.

Joe Weisenthal: Yeah.

Tracy Alloway: It was great.

Joe Weisenthal: No, it was great.

Tracy Alloway: That was excellent. Thank you so much.

Brad Setser: And just remember this last thing, just always remember Japan is selling dollars it bought between 80 and 100, depending on when they bought them, at somewhere around 160. This At the worst, you can say this operation it it reduces gross debt in a really big way.

Joe Weisenthal: Awesome. That was excellent.

Tracy Alloway: Thanks, Brad.

Joe Weisenthal: Thank you.

Tracy Alloway: Hopefully talk to you soon, but not too soon.

Joe Weisenthal: [music]

Tracy Alloway: Joe, always good to catch up with Brad and get his perspective.

Joe Weisenthal: Yeah.

Tracy Alloway: Few things stood out from that conversation. So, one, it it is kind of crazy how long the memory of the lost decade is lingering here. And we see this time and time again both in economics and the business world, which is like people just remember the past cycle, right? And it influences their current behavior. Understandably so in the case of Japan. The other thing that stood out to me is this idea of okay, the Treasury has done this sort of creative intervention in order to ease pressure on long-term Treasuries. But there seems to be a tension there with what the Fed's doing at the moment, right? So, Warsh is like, you know, like markets, you you have more of an activist say in where Treasury yields are going. It shouldn't all be about the Central Bank. And so, we've seen longer-term Treasury yields go up. So, now you have this weird situation where like Treasury clearly wants them to come down, whereas the Fed is kind of like, do your own thing.

Joe Weisenthal: Totally. There's lots of in there. One of the first things that Brad said that I thought was interesting and it sort of and it speaks to your point about the lost decade is he's like, oh, the BOJ has done all this work to get inflation back to 2%. And in my mind I was thinking like, oh, yeah, right? Like they must when he says all this work they're trying to get inflation back down. But then I remember that in Japan it's the other direction. And so, like, you know, for years the story was like, no inflation, no inflation. Maybe they just want to let it run hot a little while to fully put the lost really multiple decades of like no inflation truly in the past. I also think it is interesting and probably and no one really talks about it, the idea that Japan's fiscal position at least by certain objective measures clearly improving, clearly looking better than the trajectory of the US these days at least if you're looking at a primary deficit. And then to his point, you know, there's numerous, you know, the classical metrics that economists use to measure devaluation of a currency. We know none of them are that great as metrics go, but they all point to the end in fact being undervalued.

Tracy Alloway: Yeah.

Joe Weisenthal: Um, all right. I think we should end it there before I make a terrible turning Japanese

Tracy Alloway: Oh, you know what? I thought of a good Did you? pun, but um, someone had already used it.

Joe Weisenthal: Oh, what was it?

Tracy Alloway: Keep calm and carry on. But uh,

Joe Weisenthal: Yeah, all right.

Tracy Alloway: No, you know, it's like I'm saying it actually has only been used a handful of times. It Yeah, I just looked it up. It's just a few random um,

Joe Weisenthal: You need to make those posters. Stick them on the wall.

Tracy Alloway: Yeah, if I had been the first I would do it, but I was not.

Joe Weisenthal: All right, shall we leave it there?

Tracy Alloway: Let's leave it there.

Tracy Alloway: This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at TracyAlloway.

Joe Weisenthal: And I'm Joe Weisenthal. You can follow me at TheStalwart. Follow our producers Carmen Rodriguez at CarmenArmen, Dash Bennett at DashBot, Keal Brooks at KealBrooks, and Kevin Lozano at KevinLloydLozano. And for more Odd Lots content, go to bloomberg.com/oddlots for the daily newsletter and all of our episodes. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

Tracy Alloway: And if you enjoy Odd Lots, if you like it when we shine the Brad Setser bat signal, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there.

Joe Weisenthal: [music]

Tracy Alloway: Thanks for listening.