The defense battle for the 29 trillion U.S. debt has begun! The U.S. Treasury Secretary personally steps in to pull the lever to "save the yen," and the Federal Reserve may be forced to start a new role in "financial diplomacy."

It has been noted that the Federal Reserve may soon be drawn into actions supported by the Trump administration to aid its American ally Japan, which is struggling with its currency. U.S. Treasury Secretary Brian McGinty hopes that the politically neutral Federal Reserve will expand a loan mechanism to enable Japan to support its currency without disturbing the sensitive U.S. Treasury bond market. This request comes at a time when newly appointed Federal Reserve Chair Kevin Walsh is seeking to redefine the relationship between the Treasury and the Fed. The way both entities cooperate could have significant implications for managing the $29 trillion Treasury bond market and may give the Fed a new role in supporting U.S. financial diplomacy. It remains unclear how much support the Federal Reserve Chair has received internally for significant policy changes. On Sunday, McGinty posted on X that the U.S. has intervened in the foreign exchange market to support the yen. Japan has routinely intervened to shore up its long-weakening currency, but U.S. participation is extremely rare. The last instance was after the devastating earthquake and tsunami in 2011 when the U.S. joined a broader effort to support Japan. Since 2022, the yen has fallen sharply as the U.S. significantly raised interest rates while Japan did not follow suit. Economists have debated the factors behind the decline, which include massive debt issued by the Japanese government, a decreasing and aging population that hampers growth prospects, and recently expensive energy imports. A weak currency can trigger inflation by making imports more costly, and the Japanese government has expressed concerns over this issue multiple times. According to Factset data, last week there was a moment when 1 dollar could be exchanged for nearly 164 yen, marking the lowest level for the currency pair since 1986. Subsequently, the U.S. collaborated with Japanese authorities to support the yen. Fridays coordinated foreign exchange actions restrained the disorderly volatility of the yen, McGinty stated on Sunday. The Treasury sold euros from its foreign exchange stabilization fund to finance purchases of yen. As of Monday afternoon U.S. time, the yen had rebounded by 3.5% from its low, rising to just below the 157 mark. The purpose of this action might also concern the Treasury bond market. The interest rate spread between Japan and the U.S. fuels long-standing carry trades, where investors borrow yen at low cost and invest in higher-yielding U.S. Treasury bonds or the AI-driven boom in the U.S. stock market. However, the outlook for such trades is now in question. Tariffs and other policies of President Donald Trump have prompted global investors to hedge their dollar transactions. Thorsten Slok, chief economist at Apollo Global Management, wrote in a research report released on Sunday, Yen carry trades have broken down. Preventing the yen's decline can solidify carry trades and help maintain demand for U.S. Treasury bonds. When financial institutions, governments, or central banks sell off Treasury bonds, bond prices fall and yields rise. Before the intervention, the yield on the 10-year U.S. Treasury bond had risen above 4.7% last week, before dipping slightly back below that level. The high yield on U.S. Treasury bonds makes borrowing more expensive for consumers and businesses; McGinty has stated he is closely monitoring the 10-year Treasury yield. The intervention strategy taken by McGinty also indicates he is considering the Treasury bond market. His department sold euros rather than dollars to purchase yen. He also expressed that looking ahead, he hopes to see Japan utilize the Feds borrowing tool called the Foreign and International Monetary Authorities (FIMA) repo mechanism. The FIMA mechanism allows foreign central banks to borrow against their holdings of U.S. Treasury bonds in the short term, instead of directly selling the bonds. This avoids political and economic issues triggered by rising Treasury yields. Central banks frequently support actions to stabilize the global financial system during tense moments. However, in this case, it remains unclear whether the long-term pressures facing the yen pose any concerns regarding market liquidity or operations. For instance, Japan has the right to utilize the Feds currency swap mechanism, which allows Tokyo to exchange yen for dollars. However, Japan did not use this mechanism this time. Brad Setser, a former Treasury official now at the Council on Foreign Relations, wrote on X, The current practice is that central bank swaps are used to provide dollar funding for lender-of-last-resort types of activities, not for foreign exchange interventions. McGinty stated in his X post that he hopes to see the FIMA mechanism scaled up. The repo mechanism has a limit of $60 billion per counterparty per day. U.S. data shows that as of May, Japan held approximately $1.1 trillion in U.S. Treasury bonds. The scale of Japan's recent intervention is estimated to be between $60 billion and $80 billion. If the FIMA mechanism is applied more broadly, it could make the Treasury bond market more attractive and alleviate U.S. fiscal pressures widely. This idea could hold broad political and economic appeal, but it does not necessarily fall within the Federal Reserves remit. Expanding FIMA requires a vote by the Federal Open Market Committee (FOMC). Walsh may consider this worthwhile. Prior to his appointment as chair, he had indicated a desire to rewrite the relationship between the Fed and the Treasury known as the Treasury-Fed Accord. During his confirmation process in April, he noted that the Federal Reserve might be inclined to make concessions to the Treasury on similar issues. Walsh stated, In areas like international finance, Federal Reserve officials do not enjoy the same special status. In these matters, the Fed will work with the government and Congress. The renewed cooperation between the Federal Reserve and the Treasury could extend to other areas. The United Arab Emirates has applied for its own currency swap line, typically determined by the Fed. Walsh's views on making concessions to the Treasury suggest he may be open to considering extending currency swap lines to new countries. Moreover, he has been closely collaborating with McGinty. Walsh stated in the Senate that the two frequently communicate outside their routine weekly breakfasts as Chair of the Federal Reserve and Secretary of the Treasury.