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Arthur Hayes: Is the Bank of Japan out of the woods? How will this impact the crypto market?

BlockBeatsBlockBeats2024/08/07 02:57
By:BlockBeats

Harris will not allow a raging global financial crisis to break out before Election Day.

Original title: Spirited Away
Original author: Arthur Hayes, founder of BitMEX
Original translation: Deng Tong, Golden Finance


What do you do when the market is down but you have to win an election?


If you are a politician, the answer to this question is simple. Your first goal is to ensure re-election. Therefore, you print money and manipulate prices to rise.


Imagine that you are Kamala Harris, the Democratic candidate for the United States President, facing the powerful Orange Man (Trump). You need everything to go well because a lot of things have gone wrong since the last time you were Vice President. The last thing you need on Election Day is a raging global financial crisis.


Harris is a savvy politician. Given that she was Obama’s puppet, I bet he was warning her about how bad the 2008 Global Financial Crisis (GF) would have been if it had come to her doorstep a few months before the election. US President Joe Biden was working in his vegetable patch, so one would think Harris was in control.


The collapse of Lehman Brothers in September 2008 triggered the real GFC, just as George W. Bush was finishing his second term as president. Given that he was a Republican president, one could argue that part of Obama’s appeal as a Democrat was that he was a member of the other party and therefore not responsible for the recession. Obama won the 2008 presidential election.


Let’s refocus on Harris’ dilemma: how to respond to the GFC triggered by the unwinding of Japanese companies’ massive yen carry trades. She could let it run its course and let the free market destroy over-leveraged businesses and let wealthy baby boomer financial asset holders experience some real pain. Or, she could instruct US Treasury Secretary bad girl Yellen to fix the problem by printing money.


Like any politician, regardless of party affiliation or economic beliefs, Harris will instruct Yellen to use the monetary tools at her disposal to avert a financial crisis. Of course, that means the printing presses will start rolling in some way, shape, or form. Harris doesn’t want Yellen to wait—she wants Yellen to act forcefully and immediately. So if you agree with me that the unwinding of the yen carry trade could bring down the entire global financial system, you also have to believe that Yellen will act no later than the opening of Asian trading next Monday, August 12.


To give you an idea of the size and magnitude of the potential impact of the unwinding of the Japanese corporate carry trade, I’ll walk through an excellent research note from Deutsche Bank dated November 2023. Then, I’ll walk through how I would craft a bailout plan if I were appointed head of the U.S. Treasury.


Why does Japan always stick to the loosest monetary policy?


What is a carry trade? A carry trade is borrowing in one low-interest currency and then buying a financial asset in another currency that has a higher yield or a higher probability of appreciation. When it comes time to repay the loan, if the borrowed currency appreciates relative to the currency of the asset you purchased, the funds lose. If the borrowed currency depreciates, the funds make money. Some investors hedge currency risk, while some do not. In this case, Japanese companies do not need to hedge their borrowed yen because the Bank of Japan can print an unlimited amount of yen.


Japanese companies refer to the Bank of Japan, businesses, households, pension funds, and insurance companies. Some entities are public, some are private, but they all work together to improve Japan, or at least they intend to.


Deutsche Bank wrote an excellent report on November 13, 2023 titled "The World's Largest Carry Trade". The author poses a rhetorical question: “Why didn’t the yen carry trade explode and bring down the Japanese economy?” The situation today is very different from that at the end of last year.


The storyline is that Japan is overloaded with debt. Hedge fund bros are betting that Japan is going to collapse. But those who bet on Japan always lose. Many macro investors are too bearish on Japan because they don’t understand Japan’s combined public and private balance sheets. This is an easy psychological mistake for Western investors who believe in individual rights. But in Japan, the collective is supreme. Therefore, certain actors that are considered private in the West are just substitutes for government.



Let’s deal with the liabilities side first. These are where the money for the carry trade comes from. This is how yen is borrowed. They incur interest costs. The two main items are bank reserves and bonds and treasury bills.


Bank reserves – these are the funds that banks hold at the Bank of Japan. This amount is large because the BoJ creates bank reserves when it buys bonds. Remember, the BoJ owns nearly half of the Japanese government bond market. So the amount of bank reserves is massive, at 102% of GDP. These reserves cost 0.25%, which the BoJ pays to the banks. For reference, the Fed pays 5.4% for excess bank reserves. This financing cost is almost zero.


Bonds and T-Bills – These are government-issued Japanese government bonds. Japanese government bond yields are at rock-bottom levels due to the BoJ’s market manipulation. As of this posting, the current 10-year JGB yield is 0.77%. This financing cost is negligible.


On the asset side, the broadest item is foreign securities. These are financial assets owned abroad by the public and private sectors. One of the large private holders of foreign assets is the Government Pension Investment Fund (GPIF). With $1.14 trillion in assets, it is one of the largest pension funds in the world, if not the largest. It owns foreign stocks, bonds, and real estate.


When the Bank of Japan prices bonds, domestic loans, securities, and stocks all do well. Finally, the depreciation of the yen, due to the large amount of yen debt created, has pushed up domestic stock and real estate markets.



USDJPY (white) rose, meaning the yen weakened against the dollar. The Nasdaq 100 (green) and Nikkei 225 (yellow) also rose.


Overall, Japanese companies have taken advantage of the financial repression implemented by the Bank of Japan to finance themselves and have been highly rewarded by the weak yen. This is why the Bank of Japan has been able to continue to implement the loosest monetary policy in the world despite rising global inflation. It is really profitable.


Source: GPIF


GPIF has performed well, especially in the past decade. The yen has depreciated significantly in the past decade. As the yen depreciated, the returns on foreign assets have risen sharply.


Source: GPIF


GPIF would have lost money last quarter if it were not for the excellent returns on its overseas stock and bond portfolios. The losses on domestic bonds are because the Bank of Japan's withdrawal of YCC has caused JGB yields to rise and prices to fall. Yet the yen continues to weaken as the spread between the Bank of Japan and the Fed gets wider than Sam Bankman-Fried's eyes when he discovered the Emsam pill.


Japanese companies are trading massively. With a total exposure of 505% of Japan's GDP at about $4 trillion, they are taking on a $24 trillion value at risk. As Cardi B said, "I want you to park that big Mack truck in this little garage." She must be rapping about the Japanese men who hold power in the land of sunset.


The trade apparently worked, but the yen got too weak. At the beginning of July, the USD/JPY exchange rate was 162, which was unbearable because domestic inflation was raging then and now.


The Bank of Japan did not want to stop this trade immediately, but wanted to slowly exit over time...they always say so. Takashi Ueda succeeded Takashi Kuroda as the Governor of the Bank of Japan in April 2023, who was the main architect of this massive trade. He took the opportunity to exit. Takashi Ueda was the only fool left among the qualified candidates who wanted to commit seppuku by trying to unwind this trade. The market knew that Takashi Ueda would try to get the Bank of Japan out of this carry trade. The question was always the speed of normalization.


The Biggest Trouble for the Bank of Japan


What would a disorderly unwinding look like? What would happen to the various assets held by Japanese companies? How much would the yen appreciate?


To unwind its position, the Bank of Japan needs to raise interest rates by stopping its purchases of JGBs and eventually selling them back to the market.


On the liability side, what happens?


If the Bank of Japan doesn’t keep pushing down JGB yields, they will rise as the market demands them, with yields at least matching inflation. Japan’s consumer price index (CPI) rose 2.8% year-on-year in June. If JGB yields rise to 2.8%, higher than any bond yield at any point on the yield curve, the cost of debt of any maturity will increase. The interest costs on bond and treasury bill liabilities will surge.


The Bank of Japan will also have to raise the interest it pays on bank reserves to prevent those funds from escaping its clutches. Again, given the notional amounts involved, this cost will rise from near zero to huge.


In short, if interest rates are allowed to rise to market-clearing levels, the BoJ will have to pay billions of yen in interest each year to maintain its position. Without the proceeds from selling assets on the other side of the ledger, the BoJ will have to print huge amounts of yen to keep its debt serviced. Doing so will make the situation worse; inflation will rise and the yen will fall. So, assets must be sold.


What happens on the asset side?


The BoJ’s biggest headache is how to sell its vast trove of JGBs. Over the past two decades, the BoJ has destroyed the JGB market through its various quantitative easing (QE) and yield curve control (YCC) programs. For all intents and purposes, the JGB market no longer exists. The BoJ must force another member of the Japanese corporation to do its job and buy JGBs at prices that will not bankrupt the BoJ.


Japanese commercial banks were forced to deleverage after the real estate and stock market bubbles burst in 1989. Bank lending has been stagnant ever since. The Bank of Japan began printing money because corporations were not borrowing from banks. Given that banks are in good shape, it is time to bring several quadrillion yen worth of JGBs back onto their balance sheets.


While the Bank of Japan can tell banks to buy bonds, banks need to move the capital somewhere. As JGB yields rise, profit-seeking Japanese corporations and banks holding trillions of dollars in overseas assets will sell those assets, repatriate the capital to Japan, and deposit it in banks. Banks and these corporations will buy JGBs in large quantities. The yen appreciates due to the capital inflows, while JGB yields do not rise to levels that would cause the Bank of Japan to go bankrupt when it reduces its holdings.


The biggest loss is the fall in the prices of foreign stocks and bonds that Japanese corporations sell to generate the capital repatriation. Given the massive scale of this carry trade, Japanese corporations are the marginal price makers for stocks and bonds around the world. This is especially true for any US-listed securities, as their markets are the top destination for funding capital in the yen carry trade. Given that the yen is a freely convertible currency, many TradFi trading books reflect Japanese companies.


As the yen depreciates, more and more investors around the world are encouraged to borrow in yen and buy US stocks and bonds. Because leverage is high, as the yen appreciates, everyone rushes in at the same time.


I showed you a chart earlier that shows what happens when the yen depreciates. What happens when it appreciates a bit? Remember the earlier chart that showed USD/JPY falling from 90 to 160 in 15 years? In 4 trading days it fell from 160 to 142, as follows:



A 10% rise in USD/JPY (white) resulted in a 10% fall in the Nasdaq 100 (white) and a 13% fall in the Nikkei 225 (green). The percentage gain in the yen was about 1:1 against the decline in the stock index. Extrapolating further, if USD/JPY reached 100, a 38% gain, the Nasdaq would fall to about 12,600 and the Nikkei to about 25,365.


A rise in USD/JPY to 100 is possible. A 1% reduction in Japanese corporate carry trades is equivalent to about $240 billion in notional value. On a marginal basis, this is a huge amount of capital. Different players in corporate Japan have different secondary priorities. We saw this with Norinchubo, Japan’s fifth largest commercial bank. Their carry trade section went bust and they were forced to start unwinding their positions. They are selling foreign bond positions and covering forward USD/JPY FX hedges. This announcement was made only a few months ago. Insurance companies and pension funds will be under pressure to disclose unrealized losses and exit trades. Along with them are all the copy traders whose brokers will quickly liquidate them as currency and equity volatility rises. Remember, everyone is unwinding the same trade at the same time. Neither we nor the elites who manage global monetary policy know the total size of the yen carry trade funding positions hidden in the financial system. The opacity of the situation means a rapid overcorrection in the other direction as markets gradually unmask this highly leveraged part of the global financial system.


The Shock of the Global Financial Crisis in 2008


Why does bad girl Yellen care?


Since the 2008 global financial crisis, I think China and Japan have saved Pax Americana from a worse recession. China has undertaken one of the largest fiscal stimulus in human history, expressed through debt-fueled infrastructure development. China needs to buy goods and raw materials from the rest of the world to complete projects. Japan has printed huge amounts of money through the Bank of Japan to increase its carry trade. Japanese companies have used these yen to buy US stocks and bonds.


The US government has made a lot of money from capital gains taxes, which is a result of the stock market surge. From January 2009 to early July 2024, the Nasdaq 100 has risen 16 times and the SP 500 has risen 6 times. Capital gains tax rates are around 20% to 40%.


Despite record high capital gains taxes, the U.S. government is still running a deficit. To finance the deficit, the U.S. Treasury must issue bonds. Japanese companies are one of the largest marginal buyers of U.S. Treasuries…at least until the yen started to appreciate. Japan helps afford U.S. debt to profligate politicians who need to buy votes with tax cuts (Republicans) or various forms of welfare checks (Democrats).



The total amount of U.S. debt outstanding (yellow) is at the top right. However, the 10-year Treasury bond (white) yield has been range-bound, with little correlation to the growing debt.


My view is that the structure of the U.S. economy requires Japanese companies and their imitators to continue this carry trade. If this trade ends, the U.S. government's finances will be in tatters.


Bailout


My assumption of a coordinated bailout of Japanese corporate carry trade positions is based on the belief that Harris will not have her electoral chances diminished because some foreigners decided to exit some trade that she may not even understand. Her voters certainly don’t know what’s going on and don’t care. Their stock portfolios are either up or they’re not. If not, they won’t show up on Election Day to vote Democrat. Turnout will determine whether the Clown Emperor is Trump or Harris.


Japanese corporate positions must be closed out, but they cannot sell some assets on the open market. This means some government agency in the United States must print money and lend it to certain members of Japanese corporate.Allow me to reintroduce myself. My name is Central Bank Swap Agreement (CSWAP).


How would I have conducted a bailout if I were bad girl Yellen?


On Sunday evening, August 11, I will be issuing a communique (I am speaking as Yellen):


The U.S. Treasury, the Fed, and our Japanese counterparts have discussed at length the market turmoil of the past week. In this call, I reiterated my support for the use of the dollar-yen central bank swap lines.


That’s it. To the public, this may seem completely harmless. This is not a statement that the Fed will cave in and do aggressive rate cuts and restart quantitative easing. This is because the public knows that doing any of those things will cause already uncomfortably high inflation to accelerate again. If inflation runs rampant on Election Day and can be easily traced back to the Fed, Harris will lose.


Most American voters have no idea what CSWAP is, why it was created, or how it can be used to print unlimited amounts of money. Yet, the market will rightly view this as a stealth bailout because of what the facility will be used for.


· The Bank of Japan borrows billions of dollars and provides yen as collateral to the Fed. The number of rollovers of these swaps is determined by the Bank of Japan.


· The Bank of Japan privately talks to large corporations and banks, telling them that it is prepared to exchange dollars for U.S. stocks and U.S. Treasuries.


This transfers ownership of foreign assets from Japanese companies and banks to the Bank of Japan. These private entities own large amounts of dollars and repatriate this capital to Japan by selling dollars and buying yen. They then buy Japanese government bonds from the Bank of Japan at the current high prices/low yields. The result is an inflated size of CSWAPS outstanding, and this dollar amount is similar to the amount of money the Fed is printing.


I created an ugly box and arrow plot that will help illustrate the process.


The net effect is what matters.



Fed - They increased the supply of dollars, in other words, in return they received the yen that was previously generated by the increase in the carry trade.


CSWAP - The Bank of Japan owes the Fed dollars. The Fed owes the Bank of Japan yen.


BoJ - They now hold more US stocks and bonds, and the prices of these stocks and bonds will rise due to the rising amount of dollars due to the growing CSWAP balance.


Bank of Japan - They now hold more JGBs.


As you can see, there is no impact on US stock or bond markets, and the total carry trade exposure for Japanese companies remains the same. The yen appreciates against the dollar, and most importantly, US stock and bond prices rise due to the Fed printing dollars. The added bonus is that the Bank of Japan can issue unlimited yen-denominated loans against the newly acquired JGB collateral. This trade re-inflates both the US and Japanese systems.


Trading Advice for Cryptocurrencies


The carry trade for Japanese companies will unwind; of that, I am sure. The question is when the Fed and Treasury will print money to mitigate the impact on Pax Americana.


If the US stock market crashes on Friday, August 9, so much so that both the SP 500 and the Nasdaq 100 fall 20% from their recent July all-time highs, some kind of action could be expected over the weekend. The level for the SP 500 is 4,533; the level for the Nasdaq 100 is 16,540. I also expect the 2-year US Treasury yield to be around 3.80% or lower. This yield was reached during the regional banking crisis in March 2023, which was resolved with a bank term funding program bailout.


If the yen starts to depreciate again, the crisis will be over in the short term. Although the pace will slow down, the liquidation will continue. I think the market will have another temper tantrum between September and November as the USD/JPY pair continues to move towards 100. There will definitely be a response this time, as the US presidential election will be held in a few weeks or days.


It’s hard to trade in crypto.


Two opposing forces influence my crypto positioning.


Liquidity Positive Force:


After a quarter of net restrictive policy, the US Treasury will be a net injector of USD liquidity as it will issue T-bills and potentially drain the Treasury General Account. This policy shift was spelled out in the recent quarterly refunding announcement. TL;DR: Bad girl Yellen will inject $301 billion to $1.05 trillion between now and the end of the year. I will explain this in a follow-up article if necessary.


Liquidity Negative Force:


It’s the strength of the yen. The unwinding of the trade leads to a coordinated global sell-off of all financial assets as increasingly expensive yen debts must be repaid.


Which force is stronger really depends on how quickly the carry trades unwind. We cannot know this in advance. The only observable effect is the correlation between Bitcoin and USD/JPY. If Bitcoin is trading in a convex manner, meaning that Bitcoin rises when the USD/JPY pair strengthens or weakens significantly, then I know that the market is anticipating a bailout if the yen is too strong and liquidity provided by the US Treasury is ample. This is convex Bitcoin. If Bitcoin falls when the yen strengthens and rises when the yen weakens, then Bitcoin is trading in sync with the TradFi market. This is correlated Bitcoin.


If the market is pointing to convex Bitcoin, I would be aggressively adding to my position because we have hit a local bottom. If the market is pointing to correlated Bitcoin, then I would be sitting on the sidelines and waiting for the final market capitulation. The biggest assumption is that the Bank of Japan does not change course and cut the deposit rate to 0% and resume unlimited JGB purchases. If the Bank of Japan sticks to the plan laid out at the last meeting, the carry trades will continue to unwind.


This is the clearest guidance I can give at this time. As always, these trading days and trading months will determine your returns in this bull cycle. If you must use leverage, use it wisely and constantly monitor your positions. When you have a leveraged position, you better hold onto your bitcoin or shitcoins. Otherwise, you will be liquidated.


I still have the last of August vacation to enjoy.


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Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.

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