The Federal Reserve's policy committee said nothing about Japan in the statement on its latest meeting Tuesday. But the situation must have been discussed because Japan's response to the crisis likely will push U.S. interest rates higher.
The yen rose to its highest against the dollar since the Second World War on Wednesday. Analysts attribute much of the increase to the anticipation that Japanese insurance companies and other agencies will cash in overseas assets to pay for reconstruction.
According to Stéfane Marion, chief economist at Montreal-based National Bank Financial, most of those assets are held in the United States in the form of fixed-income securities.
Japan is the second largest holder of U.S. Treasury securities, accounting for $885.9-billion (U.S.) of a total $4.45-trillion in January, according to the Treasury Department's latest data. (China is the biggest holder of Treasuries at $1.15-trillion. The third-largest holder is Britain at $278.4-billion, mainly because so many hedge funds are based in London.)
Mr. Marion is an economist who is immune to hype - he correctly predicted in the early days of the financial crisis that Canada's recession would last about three quarters while many of his counterparts on Bay Street were declaring the worst.
In a note Wednesday, Mr. Marion didn't discount reports that suggest it will cost in excess of $100-billion to rebuild from the physical damage caused by successive earthquakes and last week's tsunami. After the Kobe earthquake in 1995, Japanese sold U.S. Treasury securities worth $30-billion in the months that followed. That was a record selloff.
A repeat of history would be felt in U.S. Treasury markets, Mr. Marion said. The Japanese selloff could be as much as 2 per cent of U.S. gross domestic product. Such a loss in demand for Treasuries would coincide with the expected end of the Fed's asset-purchase program in June, and come at a time when the U.S. government is trying to finance a deficit that is 10 per cent of GDP. Mr. Marion estimates the result could be a half- percentage-point increase in U.S. 10-year Treasury yields.
"The U.S. Treasury market would not be immune to a large wave of capital repatriation," Mr. Marion said.