Arthur Hayes Blog: Japan's Central Bank Sells U.S. Treasuries to Fuel New Bull Market in Cryptocurrency

Original Title: 《Shikata Ga Nai》

Author: Arthur Hayes

Compiled by: Ismay, BlockBeats

Editor’s Note: In the context of global economic turmoil and volatility in financial markets, Hayes delves into the challenges faced by the Japanese banking system during the Federal Reserve's interest rate hike cycle, as well as the profound impact of U.S. fiscal and monetary policy on global markets. Through a detailed analysis of the foreign exchange hedging strategies of Japan Agricultural and Forestry Central Bank and other Japanese commercial banks in U.S. Treasury investments, the article reveals the reasons these banks had to sell U.S. Treasuries amid widening interest rate differentials and rising foreign exchange hedging costs. Hayes further discusses the role of the FIMA repo mechanism and its implications for U.S.-Japan financial relations, predicting its key role in maintaining market stability. The article ultimately calls on investors to seize investment opportunities in the crypto market under the current circumstances.

Here is the blog content:

I just finished reading the first book of Kim Stanley Robinson's trilogy, "Red Mars." One character, a Japanese scientist named Hiroko Ai, often says "仕方がない" when discussing situations beyond the control of Mars colonizers, meaning "it can't be helped."

As I was thinking of a title for this "short" article, that phrase came to mind. This article will focus on the Japanese banks that have become victims of the monetary policy of "American Peace." What did these banks do? To achieve decent returns on yen deposits, they engaged in dollar-yen arbitrage. They borrowed from elderly Japanese savers domestically, looked around Japan, and found that all "safe" government and corporate bonds were yielding almost zero, leading them to conclude that lending to "American Peace" through the U.S. Treasury (UST) market was a better use of capital, as these bonds could yield higher returns even when fully hedged against exchange rate risks.

However, when massive inflation in the U.S. due to cash bribes paid to the public forced the Federal Reserve (Fed) to act, the Fed raised interest rates at the fastest pace since the 1980s. The result was bad news for anyone holding U.S. Treasuries. From 2021 to 2023, rising yields led to the worst bond market since the War of 1812. It can't be helped!

In March 2023, the losses of the first banks began to seep through the financial system. Within two weeks, three major banks collapsed, prompting the Fed to provide full support for all U.S. Treasuries on the balance sheets of any U.S. or foreign banks with branches in the U.S. As expected, Bitcoin surged significantly in the months following the announcement of the bailouts.

Since the announcement of the bailout on March 12, 2023, Bitcoin has risen over 200%

To solidify this approximately $4 trillion bailout plan (which I estimate to be the total amount of U.S. Treasuries and mortgage-backed securities held on the balance sheets of U.S. banks), the Fed announced in March that using the discount window was no longer a "kiss of death." If any financial institution needed a quick injection of cash to fill the difficult gaps on their balance sheets caused by falling prices of "safe" government bonds, they should immediately use that window. What should we say when the banking system inevitably resorts to devaluing currency and undermining the dignity of human labor for bailouts? It can't be helped!

The Fed did the right thing for U.S. financial institutions, but what about the foreigners who also bought large amounts of U.S. Treasuries during the global surge in capital from 2020 to 2021? Which country's bank balance sheets are most likely to be wrecked by the Fed? Of course, it is Japan's banking system.

Recent news shows that the fifth-largest Japanese bank will sell $63 billion worth of foreign bonds, most of which are U.S. Treasuries.

Japan Agricultural and Forestry Central Bank will sell $63 billion in U.S. and European bonds

"Rising interest rates in the U.S. and Europe have caused bond prices to fall. This has reduced the value of the high-priced (low-yield) foreign bonds previously purchased by the Agricultural and Forestry Central Bank, leading to an increase in its paper losses."

The Agricultural and Forestry Central Bank was the first to yield and announce it must sell bonds. All other banks are engaging in the same trades, which I will explain below. The Council on Foreign Relations provides us with a sense of the massive scale of bonds that Japanese commercial banks may sell.

According to the International Monetary Fund (IMF) Coordinated Portfolio Investment Survey, Japanese commercial banks held about $850 billion in foreign bonds in 2022. This includes nearly $450 billion in U.S. bonds and about $75 billion in French bonds—this figure far exceeds the bonds issued by other major Eurozone countries.

Why is this important? Because Yellen will not allow these bonds to be sold on the open market and cause U.S. Treasury yields to spike. She will require the Bank of Japan (BOJ), which supervises Japanese banks, to purchase these bonds. Then, the BOJ will utilize the FIMA repo mechanism established by the Fed in March 2020. The FIMA repo mechanism allows central bank members to pledge U.S. Treasuries and receive newly printed dollars overnight.

The increase in the FIMA repo mechanism indicates an increase in dollar liquidity in the global money market. Everyone knows what this means for Bitcoin and cryptocurrencies… This is why I think it's necessary to remind readers about another invisible money-printing avenue. I only understood how Yellen prevents these bonds from entering the open market after reading a dry Atlanta Fed report titled "Offshore Dollars and U.S. Policy."

Why Now

The Fed signaled at the end of 2021 that it would begin raising policy rates in March 2022, and since then, U.S. Treasuries (USTs) have begun to collapse. It has been over two years; why would a Japanese bank choose to confirm its losses now after enduring two years of pain? Another strange fact is that, according to the consensus view of economists you should listen to, the U.S. economy is on the brink of recession. Therefore, the Fed may lower interest rates after several meetings. Lowering rates would push bond prices up. Since all the "smart" economists are telling you that relief is just around the corner, why sell now?

The reason lies in the Agricultural and Forestry Central Bank's foreign exchange hedging purchases of U.S. Treasuries turning from slightly positive to significantly negative returns. Before 2023, the interest rate differential between the dollar and yen was negligible. Then, the Fed diverged from the BOJ by raising rates, while the BOJ maintained a -0.1% rate. As the gap widened, the cost of hedging the dollar risk embedded in U.S. Treasuries exceeded the higher yields.

Here's how it works. The Agricultural and Forestry Central Bank is a Japanese bank holding yen deposits. If it wants to purchase higher-yielding U.S. Treasuries, it must pay in dollars. The Agricultural and Forestry Central Bank will sell yen today and buy dollars to purchase the bonds; this is done in the spot market. If the Agricultural and Forestry Central Bank only does this step, and the yen appreciates before the bonds mature, it will lose money when selling dollars back to yen. For example, if you buy dollars today at USDJPY 100 and sell them tomorrow at USDJPY 99; the dollar depreciates, and the yen appreciates. Therefore, the Agricultural and Forestry Central Bank typically sells dollars and buys yen in the three-month forward market to hedge this risk. It will roll this over every three months until the bonds mature.

Typically, three-month forward contracts are the most liquid. This is why banks like the Agricultural and Forestry Central Bank use rolling three-month forward contracts to hedge ten-year currency purchases.

As the dollar-yen interest rate differential widens, the forward points turn negative because the Fed's policy rate is higher than the BOJ's rate. For example, if the spot USDJPY is 100, and the dollar's yield is 1% higher than the yen's over the next year, the one-year forward price for USDJPY should be around 99. This is because if I borrow 10,000 yen at a 0% rate to buy 100 dollars, and then deposit the 100 dollars to earn 1% interest, I will have 101 dollars after a year. What should the one-year forward price for USDJPY be to offset this $1 interest income? About 99 USDJPY, which is the no-arbitrage principle. Now imagine I did all this just to buy a U.S. Treasury that yields only 0.5% more than a similar-maturity Japanese Government Bond (JGB). I am effectively paying a -0.5% yield on this trade. If that’s the case, the Agricultural and Forestry Central Bank or any other bank would not engage in this trade.

Back to the chart, as the differential widens, the three-month forward points become so negative that the foreign exchange hedged yield of U.S. Treasuries is lower than directly purchasing yen-denominated Japanese Government Bonds. From mid-2022 onwards, you will see the red line representing the dollar fall below 0% on the X-axis. Remember, Japanese banks purchasing yen-denominated Japanese Government Bonds have no currency risk, so there’s no reason to pay for hedging costs. The only reason to engage in this trade is when the yield after foreign exchange hedging > 0%.

The situation for the Agricultural and Forestry Central Bank is worse than that of the long-position participants in FTX/Alameda. From a market value perspective, U.S. Treasuries purchased around 2020-2021 have dropped by 20% to 30%. Additionally, the cost of foreign exchange hedging has increased from negligible to over 5%. Even if the Agricultural and Forestry Central Bank believes the Fed will lower rates, a 0.25% cut is insufficient to reduce hedging costs or boost bond prices to stop the bleeding. Therefore, they must sell U.S. Treasuries.

Any plan that allows the Agricultural and Forestry Central Bank to pledge U.S. Treasuries in exchange for new dollars does not solve the cash flow problem. From a cash flow perspective, the only thing that can restore the Agricultural and Forestry Central Bank to profitability is a significant narrowing of the policy rate gap between the Fed and the BOJ. Therefore, any plan using the Fed, such as a standing repo facility, allowing foreign banks' U.S. branches to exchange U.S. Treasuries and mortgage-backed securities for newly printed dollars, is ineffective in this case.

As I write this article, I am racking my brain for any other financial means that could allow the Agricultural and Forestry Central Bank to avoid selling bonds. But as mentioned above, existing plans are some form of loans and swaps. As long as the Agricultural and Forestry Central Bank holds bonds in any form, currency risk remains and must be hedged. Only after the bonds are sold can the Agricultural and Forestry Central Bank unwind its foreign exchange hedging, which is a significant cost for them. This is why I believe the management of the Agricultural and Forestry Central Bank has explored all other options, and selling bonds is the last resort.

I will explain why Yellen is unhappy about this situation, but for now, let’s turn off Chat GPT and use our imagination. Is there a public institution in Japan that could buy bonds from these banks without fear of bankruptcy and take on the dollar interest rate risk?

Ding dong

Who’s there?

It’s the Bank of Japan.

Rescue Mechanism

The Bank of Japan (BOJ) is one of the few central banks that can utilize the FIMA repo mechanism. It can hide the price discovery of U.S. Treasuries in the following way:

The BOJ "gently suggests" any Japanese commercial bank needing to sell U.S. Treasuries directly sell those bonds onto the BOJ's balance sheet instead of selling them on the open market, settling at the current last transaction price without impacting the market. Imagine you could sell all your FTT tokens at market price because Caroline Ellison was there to support the market and could provide any necessary scale of support. Obviously, this didn’t work out well for FTX, but she doesn’t have a money printer. Her money printer can only handle $10 billion of customer funds, while the BOJ handles infinity.

Then, the BOJ uses the FIMA repo mechanism to exchange U.S. Treasuries for dollars printed out of thin air by the Fed.

One, two, tie your shoelaces. It’s that simple to bypass the free market. Man, this is a fight worth having for freedom!

Let’s ask a few questions to understand the implications of this policy.

Someone has to lose money here; the bond losses due to rising interest rates still exist. Who is the sucker?

The Japanese banks will still recognize losses by selling the bonds to the BOJ at current market prices. The BOJ now assumes the future term risk of U.S. Treasuries. If the prices of these bonds fall, the BOJ will have unrealized losses. However, this is the same risk the BOJ currently faces with its multi-trillion yen portfolio of Japanese Government Bonds. The BOJ is a quasi-government entity that cannot go bankrupt and does not need to comply with capital adequacy requirements. It also does not have a risk management department that is forced to reduce positions when its Value-at-Risk rises due to massive DV01 risk.

As long as the FIMA repo mechanism exists, the BOJ can roll over repos daily and hold U.S. Treasuries until maturity.

How is the dollar supply increasing?

The repo agreement requires the Fed to provide dollars to the BOJ in exchange for U.S. Treasuries. This loan rolls over daily. The Fed acquires these dollars through its money printer.

We can monitor the dollars injected into the system weekly. The project is called "Repo—Foreign Official."

As you can see, the FIMA repo is currently very small. But the sell-off hasn’t started yet, and I suspect there will be some interesting phone exchanges between Yellen and BOJ Governor Ueda. If I’m not mistaken, this number will increase.

Why Help Others

Americans are not known for their sympathy towards foreigners, especially those who don’t speak English and look strange. The appearance issue is relative, but to those farmers in flyover states with sunburns waving Confederate flags, the Japanese look just wrong. And you know what? These uncouth people will decide who the next emperor is this November. It’s truly speechless.

Despite potential xenophobic sentiments, the reason Yellen would extend a helping hand is that without new dollars to absorb these junk bonds, all of Japan's major banks will follow the Agricultural and Forestry Central Bank's lead and sell their U.S. Treasury portfolios to alleviate the pain. This means that $450 billion worth of U.S. Treasuries would quickly flood the market. This cannot be allowed, as yields would spike, making financing for the federal government extremely expensive.

As the Fed itself stated, this is why the FIMA repo mechanism was created:

"During the 'cash grab' in March 2020, central banks simultaneously sold U.S. Treasuries and deposited the proceeds in overnight repos at the New York Fed. In response, the Fed proposed at the end of March to agree to provide overnight loans to central banks using U.S. Treasuries held at the New York Fed as collateral, at rates higher than private repo rates. This loan would allow central banks to raise cash without forcing a thorough sale in an already strained Treasury market."

Remember September to October 2023? During those two months, the U.S. Treasury yield curve steepened, leading to a 20% drop in the S&P 500, with yields on 10-year and 30-year U.S. Treasuries exceeding 5%. In response, Yellen shifted most debt issuance to short-term Treasuries to drain cash from the Fed's reverse repo program. This boosted the market, and from November 1, all risk assets, including cryptocurrencies, began to rise.

I am very confident that in an election year, when her boss faces the threat of being defeated by the orange man (referring to Trump), Yellen will fulfill her duty to "democracy" by ensuring yields remain low to avoid a financial market disaster. In this case, all Yellen needs to do is call Ueda and instruct him not to allow Japanese banks to sell U.S. Treasuries on the open market but to use the FIMA repo mechanism to absorb the supply.

Trading Strategy

Everyone is closely watching when the Fed will finally start cutting rates. However, the dollar-yen interest rate differential is +5.5% or 550 basis points, equivalent to 22 rate cuts (assuming the Fed cuts by 0.25% at each meeting). Over the next twelve months, one, two, three, or four rate cuts will not significantly narrow this gap. Furthermore, the BOJ has shown no willingness to raise policy rates. The reasons for Japanese commercial banks to sell their foreign exchange hedged U.S. Treasury portfolios remain unresolved.

This is why I am confident in accelerating the shift from Ethena-staked USD (s USD e), currently earning 20-30% returns, to crypto risk assets. Given this news, the pain has reached a level where Japanese banks have no choice but to exit the U.S. Treasury market. As I mentioned, in an election year, the ruling Democrats most need to avoid a significant rise in U.S. Treasury yields, as this would affect the primary financial issues most concerning the median voter: mortgage rates, credit card, and auto loan rates. If Treasury yields rise, these rates will also rise.

This is precisely why the FIMA repo mechanism was established. All that is needed now is for Yellen to firmly insist that the BOJ use it.

Just as many begin to wonder where the next dollar liquidity shock will come from, the Japanese banking system sends a brand-new dollar composed of origami cranes to crypto investors. This is just another pillar of the crypto bull market. To maintain the current dollar-based dirty financial system of American Peace, the supply of dollars must increase.

Say with me, "仕方がない," and then buy the dip!