Arthur Hayes: Has the Bank of Japan escaped its predicament? How does it affect the crypto market?

Original Title: Spirited Away

Author: Arthur Hayes, Founder of BitMEX

Compiled by: Deng Tong, Jinse Finance

What do you do when the market is sluggish but you need to win an election?

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

Imagine you are Kamala Harris, the Democratic candidate for President of the United States, facing the formidable Orange Man (Trump). You need everything to go smoothly because a lot has gone wrong since you last served as Vice President. What you least need on election day is a ravaging global financial crisis.

Harris is a savvy politician. Given that she is a puppet of Obama, I bet he is warning her about the severe consequences if the 2008 global financial crisis (GF) were to hit her doorstep in the months leading up to the election. President Joe Biden is working in the vegetable garden, so people think Harris is in control.

In September 2008, Lehman Brothers went bankrupt, triggering a real global financial crisis as George W. Bush was nearing the end of his second term. Given that he was a Republican president, one might 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 economic downturn. Obama won the 2008 presidential election.

Let’s refocus on Harris's predicament: how to deal with the global financial crisis triggered by the unwinding of massive yen arbitrage trades by Japanese companies. She could let the free market destroy over-leveraged firms, allowing wealthy baby boomer financial asset holders to experience some real pain. Or, she could instruct the bad girl Yellen, the U.S. Treasury Secretary, to print money to solve the problem.

Like any politician, regardless of party affiliation or economic beliefs, Harris would instruct Yellen to use her available monetary tools to avoid a financial crisis. Of course, this means the printing press will start operating in some way, shape, or form. Harris does not want Yellen to wait—she wants Yellen to take decisive action immediately. Therefore, if you agree with my point that the unwinding of yen arbitrage trades could lead to a collapse of the entire global financial system, you must also believe that Yellen will act by next Monday (August 12) at the latest, before the Asian trading session opens.

To give you an idea of the scale and extent of the potential impact of Japanese companies unwinding their arbitrage trades, I will walk you through an excellent research report from Deutsche Bank in November 2023. Then, I will outline how I would formulate a bailout plan if I were appointed head of the U.S. Treasury.

Why Does Japan Always Stick to the Most Accommodative Monetary Policy?

What is arbitrage trading? Arbitrage trading refers to borrowing a low-interest currency and then purchasing financial assets in another currency that yield higher returns or have a higher likelihood of appreciation. When it comes time to repay the loan, if the borrowed currency appreciates relative to the currency of the asset you purchased, you incur a loss. If the borrowed currency depreciates, you make a profit. Some investors hedge currency risk, while others do not. In this case, Japanese companies do not need to hedge their borrowed yen because the Bank of Japan can print yen in unlimited quantities.

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

Deutsche Bank published an excellent report titled "The World's Largest Arbitrage Trade" on November 13, 2023. The author posed a rhetorical question: "Why hasn’t the yen arbitrage trade exploded and dragged down the Japanese economy?" The situation today is vastly different from the end of last year.

The storyline is that Japan is heavily indebted. Hedge fund brothers are betting that Japan is about to collapse. But those who bet against Japan always lose. Many macro investors are overly pessimistic about Japan because they do not understand the merged public and private balance sheets of Japan. This is an easy psychological mistake for Western investors who believe in individual rights to make. But in Japan, the collective is supreme. Therefore, certain actors that are considered private in the West are merely surrogate agencies of the government.

Let’s first address the issue of liabilities. These are the sources of funding for arbitrage trades. The yen is borrowed in this manner. 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 substantial because the Bank of Japan creates bank reserves when it purchases bonds. Remember, the Bank of Japan owns nearly half of the Japanese government bond market. Therefore, the amount of bank reserves is enormous, accounting for 102% of GDP. The cost of these reserves is 0.25%, which the Bank of Japan pays to the banks. For reference, the Federal Reserve pays 5.4% on excess bank reserves. This financing cost is almost zero.

Bonds and treasury bills—these are Japanese government bonds issued by the government. Due to the market manipulation by the Bank of Japan, the yields on Japanese government bonds are at their lowest levels. As of the publication of this article, the current yield on 10-year Japanese government bonds is 0.77%. This financing cost is negligible.

On the asset side, the most widespread items are foreign securities. These are financial assets owned abroad by the public and private sectors. The Government Pension Investment Fund (GPIF) is one of the large private holders of foreign assets. Its asset size is $1.14 trillion, making it one of the largest pension funds in the world, arguably the largest. It holds foreign stocks, bonds, and real estate.

When the Bank of Japan prices bonds, domestic loans, securities, and stocks also perform well. Finally, due to the massive issuance of yen debt, the depreciation of the yen has pushed up domestic stock and real estate markets.

The dollar against the yen (white) rises, indicating a weakening yen against the dollar. The Nasdaq 100 index (green) and the Nikkei 225 index (yellow) also rise accordingly.

Overall, Japanese companies are financing themselves through the financial repression policies implemented by the Bank of Japan and are reaping high returns due to the weak yen. This is why the Bank of Japan can continue to implement the most accommodative monetary policy in the world despite rising global inflation. It is incredibly profitable.

Source: GPIF

The GPIF has performed well, especially over the past decade. Over the past decade, the yen has depreciated significantly. As the yen depreciates, the returns on foreign assets have surged.

Source: GPIF

Without the excellent returns from its overseas stock and bond portfolio, the GPIF would have incurred losses last quarter. Domestic bond losses occurred because the Bank of Japan exited YCC, leading to rising yields and falling prices for Japanese government bonds. However, the yen continues to weaken because the interest rate differential between the Bank of Japan and the Federal Reserve is larger than the eyes of Sam Bankman-Fried when he discovered the Emsam pills.

Japanese companies have engaged in massive trading. Japan's GDP is about $4 trillion, with total exposure at 505%, and they are taking on risk valued at $24 trillion. As Cardi B said, "I hope you park that big Mack truck right in this little garage." She was surely rapping about the Japanese men in power in the Land of the Rising Sun.

This trade has clearly worked, but the yen has become too weak. At the beginning of July, the dollar-yen exchange rate was 162, which is hard to bear, as domestic inflation was rampant then and continues to be now.

The Bank of Japan does not want to stop this trade immediately; rather, it hopes to gradually unwind it over time… they always say that. Ueda Kazuo took over as Governor of the Bank of Japan in April 2023 from Kuroda Haruhiko, who was the main architect of this massive trade. He took the opportunity to exit. Ueda Kazuo is the only remaining fool among the qualified candidates hoping to commit seppuku by attempting to unwind this trade. The market knows that Ueda Kazuo will try to get the Bank of Japan out of this arbitrage trade. The question has always been the speed of normalization.

The Bank of Japan's Biggest Trouble

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, the Bank of Japan needs to raise interest rates by stopping the purchase of Japanese government bonds and eventually selling them back to the market.

What would happen on the liability side?

If the Bank of Japan does not keep suppressing Japanese government bond yields, they will rise with market demand, yielding at least matching inflation. Japan's consumer price index (CPI) rose by 2.8% year-on-year in June. If Japanese government bond yields rise to 2.8%, any bond yield above any point on the yield curve will increase the cost of debt for any term. The interest costs on the liabilities of bonds and treasury bills will skyrocket.

The Bank of Japan must also raise the interest on bank reserves to prevent these funds from escaping its grasp. Similarly, given the nominal amounts involved, this cost will rise from nearly zero to a substantial amount.

In short, if interest rates are allowed to rise to market clearing levels, the Bank of Japan will have to pay billions of yen in interest each year to maintain its positions. If there is no income from selling assets on the other side of the books, the Bank of Japan will have to print massive amounts of yen to maintain normal debt service. Doing so will worsen the situation; inflation will rise, and the yen will depreciate. Therefore, assets must be sold.

What would happen on the asset side?

The biggest trouble for the Bank of Japan is how to sell its massive holdings of Japanese government bonds. Over the past twenty years, the Bank of Japan has destroyed the Japanese government bond market through various quantitative easing (QE) and yield curve control (YCC) programs. For whatever purpose, the Japanese government bond market no longer exists. The Bank of Japan must force another member of Japanese companies to fulfill its duties to purchase Japanese government bonds at prices that will not lead to the bankruptcy of the Bank of Japan.

After the bursting of the real estate and stock market bubble in 1989, Japanese commercial banks were forced to deleverage. Since then, bank lending has been stagnant. The Bank of Japan began printing money because companies were not borrowing from banks. Given that banks are in good shape, it is now time to reintegrate tens of trillions of yen worth of Japanese government bonds back onto their balance sheets.

While the Bank of Japan can tell banks to buy bonds, banks need to move capital somewhere. As Japanese government bond yields rise, profit-seeking Japanese companies and banks holding trillions of dollars in overseas assets will sell these assets, repatriate capital to Japan, and deposit it in banks. Banks and these companies will buy Japanese government bonds in large quantities. Due to the capital inflow, the yen will appreciate, and Japanese government bond yields will not rise to levels that would cause the Bank of Japan to go bankrupt when it reduces its holdings.

The biggest losses will come from Japanese companies selling foreign stocks and bonds to generate capital repatriation. Given the massive scale of this arbitrage trade, Japanese companies are marginal price setters for global stocks and bonds. This is especially true for any U.S.-listed securities, as their markets are the preferred destination for capital financed by yen arbitrage trades. Given that the yen is a freely convertible currency, many TradFi trading books reflect the situation of Japanese companies.

As the yen depreciates, more and more global investors are encouraged to borrow yen and purchase U.S. stocks and bonds. Due to high leverage, as the yen appreciates, everyone will rush to buy at the same time.

I previously showed you a chart illustrating what happens when the yen depreciates. What happens when it appreciates slightly? Remember the earlier chart showing the dollar-yen exchange rate dropping from 90 to 160 over 15 years? In just four trading days, it dropped from 160 to 142, as follows:

The dollar-yen (white) rises by 10%, while the Nasdaq 100 index (white) falls by 10%, and the Nikkei 225 index (green) falls by 13%. The percentage increase in the yen is approximately 1:1 with the decline in stock indices. Further extrapolating, if the dollar-yen reaches 100, a 38% increase, the Nasdaq index would drop to about 12,600 points, and the Nikkei index would drop to about 25,365 points.

It is possible for the dollar-yen to rise to 100. A 1% reduction in Japanese company arbitrage trades corresponds to a nominal value of about $240 billion. Marginally, this is a huge amount of capital. Different participants among Japanese companies have different secondary priorities. We see this with Japan's fifth-largest commercial bank, Norinchukin Bank. Their arbitrage trading segment went bankrupt, and they were forced to start unwinding. They are selling foreign bond positions and covering forward dollar-yen forex hedges. This statement was released just a few months ago. Insurance companies and pension funds will face 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 stock volatility rises. Remember, everyone is unwinding the same trade at the same time. Neither we nor the elites managing global monetary policy know the total scale of the yen arbitrage trading financing positions hidden within the financial system. As the market gradually reveals this highly leveraged segment of the global financial system, the opacity of the situation means that excessive corrections can quickly occur in the other direction.

The Global Financial Crisis of 2008 Revisited

Why should bad girl Yellen care?

Since the global financial crisis of 2008, I believe that China and Japan have saved the peace under U.S. governance from a more severe economic recession. China executed one of the largest fiscal stimulus measures in human history, manifested through debt-driven infrastructure projects. China needed to purchase goods and raw materials from other countries to complete these projects. Japan printed massive amounts of money through the Bank of Japan to increase its arbitrage trades. Japanese companies used these yen to buy U.S. stocks and bonds.

The U.S. government received substantial revenue from capital gains taxes as a result of the stock market surge. From January 2009 to early July 2024, the Nasdaq 100 index rose 16 times, and the S&P 500 index rose 6 times. The capital gains tax rate is about 20% to 40%.

Despite capital gains taxes reaching historical highs, the U.S. government remains in deficit. To cover the deficit, the U.S. Treasury must issue bonds. Japanese companies are among the largest marginal buyers of U.S. Treasuries… at least they were among the largest marginal buyers before the yen began to appreciate. Japan helped the profligate politicians afford U.S. debt, as these politicians needed to buy votes with tax cuts (Republicans) or various forms of welfare checks (Democrats).

The total amount of U.S. outstanding debt (yellow) is shown in the upper right. However, the yield on 10-year Treasuries (white) has remained range-bound, almost unrelated to the growing debt.

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

The Bailout Plan

My hypothesis for coordinating a bailout of Japanese company arbitrage trading positions is based on the belief that Harris will not allow her chances of re-election to diminish because some foreigners decide to exit trades that she may not even fully understand. Her voters certainly do not know what is happening and do not care. Their stock portfolios are either up or not up. If they are not, they will not show up to vote for the Democrats on election day. Voter turnout will determine whether the clown emperor is Trump or Harris.

Japanese companies must unwind, but they cannot sell certain assets on the open market. This means that some U.S. government agencies must print money and lend it to certain members of Japanese companies. Allow me to reintroduce myself. My name is Central Bank Currency Swap (CSWAP).

If I were bad girl Yellen, how would I conduct the bailout?

On the evening of Sunday, August 11, I would issue a communiqué (speaking as Yellen):

The U.S. Treasury, the Federal Reserve, and their Japanese counterparts have discussed the market turmoil over the past week in detail. During this conference call, I reiterated my support for utilizing the dollar-yen central bank swap lines.

That’s it. To the public, this seems completely harmless. This is not a statement of the Federal Reserve capitulating and engaging in aggressive rate cuts and restarting quantitative easing. This is because the public knows that doing any of these things would lead to an already troubling high inflation accelerating again. If inflation is rampant on election day and can easily be traced back to the Federal Reserve, Harris will lose.

Most American voters do not know what CSWAP is, do not know why it was created, and do not know how it is used to print unlimited amounts of money. However, the market will correctly view this as an invisible bailout because of what this tool will be used for.

• The Bank of Japan borrows billions of dollars and provides yen as collateral to the Federal Reserve. The number of rollovers for these swaps is determined by the Bank of Japan.

• The Bank of Japan privately talks to large corporations and banks, telling them it is ready 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 hold large amounts of dollars and will repatriate this capital to Japan by selling dollars and buying yen. They then purchase Japanese government bonds from the Bank of Japan at current high prices/low yields. The result is that the outstanding CSWAPs balloon in size, and this dollar amount is similar to the amount of money printed by the Federal Reserve.

I created an ugly box arrow diagram to help illustrate the process.

The net effect is what matters most.

Federal Reserve—they increase the dollar supply, in other words, in return, they receive the yen generated by the previous growth of arbitrage trades.

CSWAP—the Bank of Japan owes the Federal Reserve dollars. The Federal Reserve owes the Bank of Japan yen.

Bank of Japan—they now hold more U.S. stocks and bonds, and as the CSWAP balance grows, the dollar amount increases, which will push up the prices of these stocks and bonds.

Japanese Banks—they now hold more Japanese government bonds.

As you can see, the U.S. stock or bond markets are unaffected, and the total arbitrage trading risk of Japanese companies remains unchanged. The yen appreciates against the dollar, and most importantly, due to the Federal Reserve printing dollars, the prices of U.S. stocks and bonds rise. An additional benefit is that Japanese banks can issue unlimited yen-denominated loans using the newly acquired Japanese government bonds as collateral. This trade allows both the U.S. and Japanese systems to re-inflate.

Trading Advice for Cryptocurrencies

Japanese companies' arbitrage trades will unwind; I am quite sure of this. The question is when the Federal Reserve and the Treasury will print money to mitigate its impact on the peace under U.S. governance.

If the U.S. stock market crashes on Friday, August 9, such that both the S&P 500 index and the Nasdaq 100 index drop 20% from their recent historical highs in July, some action may be taken over the weekend. The S&P 500 index level is 4,533; the Nasdaq 100 index level is 16,540. I also expect the 2-year U.S. Treasury yield to be around 3.80% or lower. This yield was reached during the regional banking crisis in March 2023, which was resolved through the Bank Term Funding Program.

If the yen begins to depreciate again, the crisis will end in the short term. Although the pace will slow, the unwinding will continue. I believe that as the dollar/yen pair continues to approach 100, the market will throw another tantrum between September and November. This time there will definitely be a response, as the U.S. presidential election will take place in a few weeks or days.

Trading in cryptocurrencies is difficult.

Two opposing forces are affecting my cryptocurrency positioning.

Positive Liquidity Force:

After a quarter of net restrictive policies, the U.S. Treasury will net inject dollar liquidity as it issues treasury bills and may deplete the total account of the Treasury. This policy shift was outlined in the recent quarterly refinancing announcement. TL;DR: Bad girl Yellen will inject $301 billion to $1.05 trillion from now until the end of the year. If necessary, I will explain this in subsequent articles.

Negative Liquidity Force:

This is the strengthening of the yen. The unwinding of trades leads to a globally coordinated sell-off of all financial assets, as increasingly expensive yen debt must be repaid.

Which force is stronger actually depends on the speed of the unwinding of arbitrage trades. We cannot know this in advance. The only observable effect is the correlation between Bitcoin and the dollar/yen. If Bitcoin trades in a convex manner, meaning it rises when the dollar/yen pair strengthens or weakens significantly, then I know that if the yen is too strong and liquidity provided by the U.S. Treasury is ample, the market will anticipate a bailout. This is convex Bitcoin. If Bitcoin falls when the yen strengthens and rises when the yen weakens, then Bitcoin will trade in sync with the TradFi market. This is correlated Bitcoin.

If the market points to convex Bitcoin, I will actively increase my position because we have reached a local bottom. If the market points to correlated Bitcoin, I will stand aside and wait for the ultimate market capitulation. The biggest assumption is that the Bank of Japan will not change direction, lowering deposit rates to 0% and resuming unlimited purchases of Japanese government bonds. If the Bank of Japan sticks to the plan set out in the last meeting, the arbitrage trades will continue to unwind.

This is the clearest guidance I can offer at the moment. As always, these trading days and months will determine your returns in this bull market cycle. If you must use leverage, do so wisely and continuously monitor your positions. When you have leveraged positions, it is best to safeguard your Bitcoin or junk coins. Otherwise, you will be liquidated.

I still have a little time left to enjoy my August holiday.