• The Bank of Japan intervened in the currency market this week for the first time in more than two decades
• Despite the strong signal that it won't tolerate a weak yen, the central bank has limited firepower
• The USD/JPY exchange rate recovered from the lows as investors are still willing to sell the yen

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A wild week for the currency traders just ended on Friday. The US dollar surged across the board, especially on the last trading day of the week, but there is more to consider than the dollar’s strength.

One is the British pound’s weakness, which I discussed here.

Another is the Bank of Japan’s first intervention in the currency market since 1998. The move triggered an epic move lower in the JPY pairs, busting many bulls.

Even the USD/JPY exchange rate dropped from close to 146 to below 141 – significant, given the dollar’s overall strength. Because it happened in a matter of hours, if not minutes, the JPY’s strength took many short traders out.

But if history tells us something, currency intervention is no strategic solution in the long run. Moreover, the Bank of Japan’s resources to fight the yen’s weakness are limited if not accompanied by rate hikes.

Bank of Japan has limited firepower

A central bank intervening in the currency market is a bold move. If in doubt, just look back at the Swiss National Bank’s losses while preserving the EUR/CHF peg at 1.20. It was forced to give up to the 1.20 floor, triggering a seismic move in the currency market.

The Bank of Japan’s direct intervention to prop up the yen is not something to ignore. After all, only the fact that it happened for the first time in more than two decades tells us something about the issue at hand.

But the Bank of Japan has limited firepower. To understand why let us break down the intervention into small pieces.

As it turns out, the Bank of Japan holds US Treasury bonds and dollars as foreign exchange reserves. The intervention was in the USD/JPY exchange rate, and the other ones simply followed.

Therefore, to prop up the yen, the Bank of Japan sold dollars held in reserve and bought yens in the open market. But suppose one considers the foreign exchange turnover in Japan and the size of Japan’s foreign exchange reserves. In that case, the firepower to intervene in the currency market is limited to about three days or so. 

In other words, if not accompanied by bolder moves, such as an interest rate hike or more, the yen’s weakness would likely resume.

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