Author: Arthur Hayes, co-founder of BitMEX; Translated by Deng Tong, Golden Finance
I just finished reading Red Mars, the first book in Kim Stanley Robinson’s trilogy. One of the characters in the book, Japanese scientist Hiroko Ai, frequently says “nothing can be done” when referring to situations beyond the control of the Martian colonists.
This quote came to mind when I was thinking of a title for this "short article". This short article will focus on the Japanese banks that fell victim to the US monetary policy. What did these banks do? In order to earn a decent yield on yen deposits, they engaged in the dollar-yen carry trade. They borrowed from elderly savers in Japan, looked around Japan and saw that all the "safe" government and corporate bonds were yielding close to zero, and concluded that lending to the US through the US Treasury (UST) market was a better use of capital, as the yields on these bonds were many percentage points higher even when fully FX hedged.
But then, when inflation hit the US, the Federal Reserve (Fed) had to act. The Fed raised interest rates at the fastest pace since the 1980s. As a result, it was bad news for anyone holding UST. From 2021 to 2023, rising yields produced the worst bond cycle since the War of 1812. What to do!
March 2023 began with the first banking disaster in the United States that penetrated the bottom of the financial system. In less than two weeks, three major banks failed, leading the Federal Reserve to provide full support for all USTs held on the balance sheet of any US bank or US branch of a foreign bank. As expected, Bitcoin soared in the months after the bailout was announced.
Since the bailout was announced on March 12, 2023, Bitcoin has risen more than 200%.
In order to consolidate the bailout of about $4 trillion (this is my estimate of the total amount of USTs and mortgage-backed securities held on the balance sheets of US banks), in March this year, the Fed announced that the use of the discount window is no longer fatal. If any financial institution needs a quick injection of cash to fill the thorny hole in its balance sheet due to negative assets of "safe" government bonds, the said window should be used immediately. When the banking system is inevitably bailed out by devaluing the currency and violating the dignity of human labor, what will we say? What should be done!
The Fed is doing the right thing with US financial institutions, but what about the foreigners who also bought UST in large quantities from 2020 to 2021 as global currencies soared? Which country's bank balance sheets are most likely to be brought down by the Fed? Of course, the Japanese banking system.
In the latest news, we learn why the fifth largest Japanese bank by deposit size is selling $63 billion worth of foreign bonds, mostly USTs.
"Rising interest rates in the U.S. and Europe and falling bond prices have reduced the value of high-priced (low-yielding) foreign bonds that Norinchukin Bank (Norinchukin Bank is a Japanese cooperative bank that invests in bonds, securitized products, stocks, private equity, and real estate through overseas branches in New York City, London, and Singapore) had purchased in the past, leading to a widening of its paper losses."
The Norinchu "Nochu" bank was the first to surrender and announce that it had to sell bonds, and all the other banks engaged in the same trade, which I will explain below, and the Council on Foreign Relations gives us some idea of the huge amount of bonds that Japanese commercial banks may be selling.
Japanese commercial banks held about $850 billion of foreign bonds in 2022, according to the International Monetary Fund’s coordinated survey of portfolio investment. That included nearly $450 billion in U.S. bonds and about $75 billion in French debt — a sum far larger than their holdings of bonds issued by other large eurozone countries.
Why is this important? Because Yellen will not allow these bonds to be sold on the open market and spike UST yields. She will ask the Bank of Japan (BOJ) to buy these bonds from the Japanese banks it supervises. The BOJ will then use the Foreign and International Monetary Authorities (FIMA) repo facility established by the Federal Reserve in March 2020. The FIMA repo facility allows central bank members to pledge UST and receive newly printed dollar bills overnight.
The increase in FIMA repo agreements indicates an increase in USD liquidity in global money markets. You all know what this means for Bitcoin and cryptocurrencies… That’s why I thought it was important to alert readers to another avenue of covert money printing. It took me reading a dry report from the Atlanta Fed titled “Offshore Dollars and U.S. Policy” to understand how Yellen could keep these bonds from hitting the open market.
Why now?
UST started to collapse in late 2021 as the Fed signaled that it would raise policy rates starting in March 2022. It's been more than two years; why would a Japanese bank be losing money after two years of pain? Another odd fact is the consensus among economists you should listen to: the US economy is on the brink of a recession. Therefore, the Fed is a few meetings away from cutting rates. A rate cut would push bond prices higher. Then again, if all the "smart" economists are telling you relief is coming, why sell now?
The reason is that the UST purchased by Nochu for FX hedging has gone from a slight positive spread to a huge negative spread. Before 2023, the difference between the USD and JPY exchange rates was ignored. Then, the Fed went against the Bank of Japan and raised interest rates, while the Bank of Japan stuck to -0.1%. As the spread widened, the cost of hedging the USD exposure in UST exceeded the higher yield provided.
Here's how it works. Nochu is a Japanese bank that has yen on deposit. If it wants to buy the higher-yielding UST, it has to pay for that bond in dollars. Nochu will sell yen today and buy dollars to buy that bond; this is done in the spot market. If that's all Nochu does, and the yen appreciates between now and when the bond matures, then Nochu loses money when it sells the dollars back into yen. For example, you buy dollars today for 100 yen and sell them tomorrow for 99 yen; the dollar weakens and the yen strengthens. So Nochu will sell dollars and buy yen (usually three-month forwards) to hedge that risk. It will roll forward every three months until the bond matures.
Typically, 3m tensors are the most liquid. That is why banks like Nochu use rolling 3m forwards to hedge 10-year currency purchases.
Since the Fed's policy rate is higher than the BoJ's, the USDJPY spread widens and the forward point turns negative. For example, if the spot USDJPY is 100, and the USD yields 1% higher than the JPY next year, the USDJPY 1-year forward should trade around 99. This is because if I borrow 10,000 JPY at 0% to buy 100 USD today, and then deposit 100 USD to earn 1%, I will have 101 USD a year from now. What is the USDJPY 1-year forward price to offset the 1 USD interest income? ~99 USDJPY, which is the no-arbitrage principle. Now imagine that I did all of this to buy UST, which only yields 0.5% higher than JGB of similar maturity. I am essentially paying a negative 0.5% carry to hold this position. If that were the case, Nochu or any other bank would not enter into this trade.
Returning to the chart, as the spread widens, the 3m forward point becomes so negative that the UST bond FX hedged yen yield is less than just buying the yen-denominated JGBs. This is what you see starting in mid-2022, with the red line for USD crossing below 0% on the X-axis. Remember, the Japanese bank buying the JGBs in yen has no currency risk, so there is no reason to pay the hedging fee. The only reason to do this trade is when the FX hedged yield is >0%.
Nochu is in a worse spot than FTX/Alameda Polycule participants. UST purchased in 2020-2021 is most likely down 20%-30% at market value. In addition, FX hedging costs have gone from unacceptable to over 5%. Even if Nochu believes the Fed will cut rates, a 0.25% cut will not reduce hedging costs or increase bond prices to stop the bleeding. Therefore, they must dump UST.
Any plan that allows Nochu to stake UST in exchange for new dollars will not solve the negative cash flow problem. From a cash flow perspective, the only thing that could turn Nochu back into the black is a significant narrowing of the gap in policy rates between the Federal Reserve and the Bank of Japan. So using any of the Fed's programs, such as the Standing Repo Facility that allows U.S. branches of foreign banks to repurchase USTs and mortgage-backed securities in newly printed dollars, won't help in this situation.
As I write this, I am racking my brain to think of any other financial shenanigans Nochu could pull that would allow it to avoid selling the bonds. But as I mentioned above, the existing scheme to help the banks lie about unrealized losses is some sort of loan and swap. As long as Nochu owns the bonds in some way, shape or form, the currency risk remains and must be hedged. Only by selling the bonds can Nochu unwind its FX hedge, which would be costly. That is why I believe Nochu's management would explore all other options, and selling the bonds is a last resort.
I'll explain why Yellen is upset about this situation, but for now, let's turn off Chat GPT and use our imaginations. Is there a Japanese public institution that could buy bonds from these banks and store the dollar interest rate risk without having to worry about bankruptcy?
who is it?
It's the fucking Bank of Japan.
Rescue Mechanism
The Bank of Japan is one of the few central banks that has access to the FIMA repo facility. This allows it to obscure UST price discovery by:
The BoJ gently “suggested” that any Japanese commercial bank that needed to exit should not sell UST on the open market, but instead dump those bonds directly onto the BoJ’s balance sheet and receive the current last traded price without affecting the market. Imagine you could dump all FTT tokens at market price, because Caroline Elison could support a market of any size necessary. Obviously, this wouldn’t work well for FTX, but she’s not a central bank with a printing press. Her printing press only printed $10 billion of customer funds at most. The BoJ’s transactions are unlimited.
The BoJ then exchanges the UST for dollar bills that the Fed prints out of thin air through the FIMA repo facility.
It's so easy to avoid the free market. Man, that's a freedom worth fighting for!
Let’s ask a few questions to understand what the above policy means.
Someone is definitely losing money here; losses on bonds due to rising interest rates are still there.
The Bank of Japan still materializes losses on the bonds because they sell them to the BoJ at current market prices. The BoJ currently faces UST duration risk. If the price of these bonds falls, the BoJ will have unrealized losses. However, this is the same risk that the BoJ currently faces with its multi-trillion yen portfolio of Japanese government bonds. The BoJ is a quasi-governmental entity that cannot go bankrupt and does not have to comply with capital adequacy ratios. It also does not have a risk management department that would forcefully reduce positions if its VaR rises due to large DV01 risk.
As long as the FIMA repo exists, the BoJ can roll over the repo daily and hold the UST until maturity.
How does the dollar supply increase?
The repo agreement requires the Fed to provide dollars to the Bank of Japan in exchange for UST. This loan is made daily. The Fed obtains these dollars by using its printing press.
We can monitor the dollars pumped into the system on a weekly basis. The line item is "Repurchase Agreements - Foreign Officials."
As you can see, the FIMA repository is currently very small. But the sell-off has not started yet, and I guess there will be some interesting phone calls between Yellen and BoJ Governor Ueda. If I am right, this number will rise.
Why help others?
It’s no secret that Americans are not very sympathetic to foreigners, especially those who don’t speak English and look funny.
The reason Yellen came to the rescue in the face of potential xenophobia is that without new dollars to absorb these shitty bonds, all the big Japanese banks will follow Nochu's lead and sell off their UST portfolios to ease the pain. This means $450 billion worth of UST will be quickly put on the market. This cannot be allowed because yields will soar and make funding the federal government extremely expensive.
In the Fed’s own words, this is why the FIMA repo facility was created:
In March 2020, during the “cash rush”, central banks around the world simultaneously sold off U.S. Treasuries.
The proceeds were deposited in overnight repurchase agreements at the New York Fed. In response, the Fed agreed to provide overnight advances to the central bank in US dollars at the end of March.
The New York Fed holds U.S. Treasuries as collateral at an interest rate higher than private repo rates.
Such advances would allow the central bank to raise cash without forcing an outright sale of securities.
The Treasury market is already nervous.
Remember September-October 2023? In those two months, the UST yield curve steepened, causing the S&P 500 to fall 20%, and the yields on 10-year and 30-year USTs were over 5%. In response, Bud Gur Yellen switched most of the debt issuance to short-term Treasuries to drain the cash in the Fed's reverse repo program. This stimulated the market, and starting on November 1st, the race began for all risk assets (including cryptocurrencies).
I am very confident that in an election year, when her boss is facing a disastrous defeat at the hands of the felons of the “Orange Man”, Yellen will do her “democratic” duty and ensure that yields remain low to avoid a financial market disaster. In this case, all Yellen needs is to call Ueda and instruct him not to allow the Bank of Japan to sell UST on the open market and that he should use the FIMA repo facility to absorb the supply.
Trading straregy
Everyone is highly focused on when the Fed will finally start cutting rates. However, assuming the Fed cuts rates by 0.25% each time at the next meeting, the USD/JPY spread is +5.5% or 550 basis points or 22 rate cuts. One, two, three or four rate cuts in the next twelve months will not materially reduce the spread. In addition, the Bank of Japan has not shown any willingness to raise its policy rate. At most, the Bank of Japan may slow the pace of open market bond purchases. The reason why Japanese commercial banks must sell FX-hedged UST portfolios has not been resolved.
That’s why I’m confident in a quick transition from Ethena collateralized USD (sUSDe) (yield 20-30%) to crypto exposure. Given this news, the Bank of Japan has no choice but to exit the UST market. As I mentioned, in an election year, the last thing the ruling Democratic Party needs is a big rise in UST yields that would affect the big financial concerns of their median voter. Namely mortgage rates, credit card rates, and auto loan rates. These will all go up if Treasury yields climb.
This situation is exactly why the FIMA repo facility was established. All that is needed now is for Yellen to firmly insist that the BoJ use it.
Just when many were beginning to wonder where the next shock to USD liquidity would come from, the Japanese banking system dropped an origami crane consisting of neatly folded USD bills into the lap of cryptocurrency investors. This is just another prop for the cryptocurrency bull market. The USD supply must increase to maintain the current filthy USD-based financial system.
