Bitcoin and the dollar have collapsed across the board, behind Black Monday: Yen arbitrage trades reversed

Author: Deep Tide TechFlow

A butterfly flapping its wings in Brazil could cause a tornado in Texas a month later.

On July 31, the Bank of Japan raised its policy interest rate from around 0% to 0.25%, marking the first interest rate hike since Japan ended its negative interest rate policy in March this year.

Over the past month, the yen has appreciated by about 8% against the dollar, as expectations of narrowing interest rate differentials between the U.S. and Japan heat up, leading to a global "liquidation" trend in arbitrage trading.

Some global financial markets experienced a Black Monday.

The Japanese stock market saw an epic plunge, with the Nikkei index plummeting by 9%, and the Tokyo Stock Exchange index triggered circuit breakers twice, recording the largest single-day drop in eight years. The stock markets in South Korea and Taiwan were not spared.

The South Korean market opened with a drop of over 4%, with Samsung's stock price falling by 5%, marking the largest decline since 2020, prompting the Korea Exchange to implement temporary trading suspension measures.

U.S. stock index futures continued to decline, with the Nasdaq 100 futures dropping by 2%. The yield on U.S. 2-year Treasury bonds fell by 9 basis points, reaching the lowest level since May 2023, and the dollar index dropped to around 103. It is foreseeable that tonight's U.S. stock market will again face a bloodbath.

However, the most severely affected is still the cryptocurrency market.

Bitcoin once fell to around $54,000, while Ethereum dropped to around $2,100, with a single-day decline of nearly 20%, resulting in $800 million in liquidations within 24 hours, and the total market capitalization of the cryptocurrency market fell below $2 trillion.

In retrospect, this global sell-off may have been caused by the reversal of yen arbitrage combined with the turbulent situation in the Middle East.

What is yen arbitrage trading?

Currency arbitrage trading is a type of carry trade, which involves borrowing a currency with a lower interest rate to invest in financial assets with a higher interest rate or expected return.

Due to Japan's long-standing low interest rates, market participants borrow money at low rates in Japan and then convert the funds into dollars or other currencies to invest in assets in high-interest countries.

The peak of yen arbitrage trading began in 2004. To stimulate economic recovery, the Bank of Japan implemented a "zero interest rate" policy from March 2001 to July 2006. In contrast, during this period, countries in Europe and the U.S. frequently raised interest rates, leading to higher interest levels. Investors borrowed yen and purchased high-yield currencies like dollars and euros in the foreign exchange market for investments in stocks, real estate, and other markets, or directly bought high-yield assets denominated in these high-interest currencies to profit.

Yen arbitrage trading has historically supported bull markets in global equities, allowing cheap currency funds to be invested elsewhere.

A typical case is Warren Buffett borrowing yen to buy stocks in Japanese trading companies last year, fully hedging against the risk/reward of the yen exchange rate, focusing on the cash cow stability of large Japanese trading companies.

Meanwhile, U.S. stocks have maintained a "long bull" market despite the impact of dollar interest rate hikes, continuing to reach new highs thanks to yen arbitrage trading, which has provided ample liquidity.

Bitcoin has similarly benefited from the long-term depreciation of the yen.

In May, BitMEX founder Arthur Hayes wrote an article bullish on Bitcoin, believing that a weak yen could push Bitcoin to $1 million. Arthur pointed out that the dollar/yen exchange rate is one of the most important variables in the global economy, and the complex interactions of monetary policies among the U.S., China, and Japan, along with their profound impacts on the global economy, influence the trends in the cryptocurrency market.

When mentioning the situation of the yen continuously depreciating due to the widening U.S.-Japan interest rate differential, Arthur noted that the Bank of Japan would be reluctant to raise interest rates because it is the largest holder of Japanese government bonds. When interest rates rise, bond prices fall, meaning the Bank of Japan would bear the largest losses. However, if the Bank of Japan does not raise rates while the Federal Reserve does not cut rates, the dollar/yen interest rate differential will still exist. With U.S. yields higher than those of the yen, investors will continue to sell yen, leading to further depreciation of the yen.

" In the face of global fiat currency depreciation, Bitcoin is the best-performing asset, and they know this. When measures are taken against a weak yen, I will mathematically predict how the funds flowing into the Bitcoin complex will push the price to $1 million, or even higher," Arthur predicted.

However, the situation developed contrary to Arthur's predictions, as the yen did not continue to depreciate; instead, the Bank of Japan began raising interest rates.

Historically, every reversal of yen arbitrage trading has the potential to trigger a crisis, as one major side effect of yen arbitrage trading is to fuel asset bubbles in the relevant countries and markets, especially in emerging market countries.

A massive amount of yen liquidity is widely spread across global stock markets, foreign exchange markets, and commodity markets, becoming a significant force influencing global market trends. Its rapid flow in the global market also casts many shadows of unease over international financial markets. For this reason, from the International Monetary Fund to the Bank for International Settlements, there have been repeated warnings about the dangers of yen arbitrage trading.

The International Monetary Fund (IMF) has released reports studying the relationship between yen arbitrage trading and the subprime mortgage crisis. The report pointed out that the end of yen arbitrage trading often leads to capital withdrawal, triggering a global decline in asset prices, and as financial institutions deleverage, it results in credit tightening.

Specifically, the impacts of the reversal of yen arbitrage trading are mainly reflected in the following aspects:

Asset price volatility: The unwinding of yen arbitrage trading leads to capital withdrawal from high-yield risk assets, which typically triggers a decline in asset prices.

Credit market tightening: When financial institutions begin to unwind yen arbitrage trading, they need to reduce leverage by selling assets and repaying debts, leading to reduced liquidity in the credit market and further tightening of credit conditions.

Changes in risk appetite: The "fear index" VIX is negatively correlated with the scale of yen arbitrage trading. When market participants expect low risk and high returns, the scale of yen arbitrage trading increases, and vice versa.

Worsening of the subprime crisis: As financial institutions unwind their arbitrage positions, the prices of subprime-related assets further decline, exacerbating credit market tightening and financial institution losses.

Recently, the significant decline in U.S. stocks, led by the technology sector, largely indicates a massive reverse liquidation of arbitrage trading.

According to a report released by Citigroup analysts Osamu Takashima AC, Daniel Tobon, and Brian Levine, the threshold for the U.S.-Japan interest rate differential to turn downward after an upward trend in the dollar/yen exchange rate was previously about 4.75%. Currently, this differential is about 5.25%, and reaching this level may require the Federal Reserve to implement three rate cuts, a process that would take about six months.

Respect the market and risk!