The US-Japan yen intervention is drawing attention to another challenge for Treasurys

• Everyone's watching the yen after the US and Japan intervened to support the currency.
• Markets feared Japan might have to sell Treasurys to defend the yen.
• But another challenge may be where Japanese investors put their money.

Washington and Tokyo's rare joint intervention to support the yen has put renewed focus on Japan, the largest foreign holder of US Treasurys.

Early on Tuesday, the dollar-yen pair traded at around 157 against the dollar after rebounding from a nearly four-decade low of around 164, following intervention by US and Japanese authorities on Friday.

The coordinated intervention followed months of yen weakness that pushed the currency to a roughly 40-year low and drove up Japan's import prices. The weaker yen also added pressure to Japan's government bond market, ING strategists wrote in a note Monday.

As speculation grew over how Japan would fund future currency intervention, Treasury investors took notice.

Because supporting the yen requires buying yen with dollars, investors worried Japan might eventually have to sell some of its US Treasury holdings to fund further intervention.

Japan was the largest foreign holder of US government debt as of May, per the latest Treasury data, so any large-scale sales could put upward pressure on Treasury yields.

"The higher risk premium of JPY does not immediately trigger large spillovers to markets abroad, but the selling of UST holdings by Japan would pose a more material risk," ING's strategists wrote.

On Monday, Japan's finance minister said Tokyo could instead use the Federal Reserve's FIMA facility, which allows foreign central banks to borrow dollars against their US Treasury holdings rather than sell the securities outright.

But investors may be overlooking a more lasting challenge for Treasury demand.

In recent months, the benchmark 10-year Japanese government bond yield has risen to its highest level since the 1990s as investors have increasingly demanded greater returns to hold Japanese government bonds.

Japanese investors have historically bought US Treasurys when they offered a better return than Japanese government bonds after hedging currency risk, the ING strategists wrote.

But higher Japanese bond yields are making domestic government debt increasingly competitive with currency-hedged US Treasurys, giving Japanese investors more reason to keep money at home.

If Japanese investors increasingly favor domestic government bonds over currency-hedged US Treasurys, Japanese demand for US government debt could weaken just as Washington needs foreign buyers to help absorb record borrowing.

"With the record US deficit unlikely to be addressed anytime soon, foreign buyers will need to play an important role to prevent UST yields from breaking higher," the ING strategists wrote.

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