By Arthur Hayes
Compiled by: Pzai, Foresight News
Any opinions expressed in this article are the author’s personal opinions and should not form the basis for investment decisions or be regarded as recommendations or suggestions to engage in investment transactions.
What do you do when the market is down but you're trying to win an election? If you're a politician, the answer is obvious: your primary goal is to secure reelection. So you print money and manipulate prices higher.
Imagine you are Democratic presidential candidate Kamala Harris, facing off against a powerful Orange Man. You need everything to go right because a lot has gone wrong since the last election when 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 running mate, I bet he whispered in her ear how bad it would be if the 2008 global financial crisis came to her doorstep a few months after the election. President Joe Biden is no longer in the picture, so let’s assume Harris is running the show.
In September 2008, as George W. Bush was finishing his second term as president, Lehman Brothers collapsed, kicking off the global financial crisis. Given that he was a Republican president, one could argue that Obama’s appeal as a Democrat was partly because he was a member of the other party and therefore not responsible for the recession. Obama went on to win the 2008 presidential election. Let’s return to Harris’ dilemma of how to respond to the global financial crisis sparked by Japan’s massive yen carry trade. She could choose to let the free market destroy over-leveraged businesses and let wealthy baby boomer financial asset holders experience some real pain. Or, she could instruct U.S. Treasury Secretary Bud Yellen to solve the problem by printing money.
Like any politician, regardless of party or economic beliefs, Harris will instruct Yellen to use the monetary tools at her disposal to avoid a financial crisis. Of course, that means the printing presses will be humming in some way, shape, or form. Harris will not want Yellen to wait, she will want Yellen to take strong action now. So if you agree with me that this unwinding of the yen carry trade could cause the entire global financial system to collapse, then you also have to believe that Yellen will act no later than the opening of the Asian trading day next Monday (August 12).
To give you an idea of the size and severity of the potential impact of the unwinding of carry trades for Japanese companies, I will present an excellent research article published by Deutsche Bank in November 2023. Then, I will walk you through how I would structure a bailout package if I were appointed head of the U.S. Treasury.
Widow Maker
What is a carry trade? A carry trade is when you borrow money in one currency with a low interest rate and buy a financial asset with another currency that has a higher yield or a greater chance of appreciation. When it comes time to repay the loan, you lose money if the borrowed currency appreciates relative to the currency of the asset you purchased. You make money if the borrowed currency depreciates. Some investors hedge their currency risk, some don't. In this case, since the Bank of Japan can print an unlimited amount of yen, there is no need for Japanese companies to hedge their borrowed yen.
Japan Inc. refers 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 conditions in Japan, or at least they intend to do so. Deutsche Bank wrote an excellent report on November 13, 2023 titled "The World's Largest Carry Trade." The author asks a rhetorical question: "Why didn't the yen carry trade blow up and bring down the Japanese economy?" The situation today is very different from the end of last year.
The narrative is that Japan is over-indebted. Hedge fund after hedge fund bets that Japan is going to collapse, but they always lose. This is the so-called "Widow Maker" trade. Many macro investors are too bearish on Japan because they don't understand Japan's combined public and private balance sheet. This is an easy psychological mistake for Western investors who believe in individual rights above all else, but in Japan, the collective is supreme. Therefore, certain front men who are considered private in the West are just white gloves for the government.
Let's look at the liabilities first. These are where the money for the carry trade comes from. This is how the yen is borrowed. They come with interest costs. The two main items are bank reserves and bonds and treasury bills.
Bank reserves - This is the money that banks hold with the Bank of Japan. This is a large amount because the Bank of Japan generates bank reserves when it buys bonds. Remember, the Bank of Japan owns nearly half of the Japanese government bond market. Therefore, bank reserves are huge, accounting for 102% of GDP. The cost of these reserves is 0.25%, which is paid by the Bank of Japan to the banks. The cost of excess bank reserves at the Fed is 5.4%. This funding cost is effectively zero.
Bonds and Treasury Bills - These are Japanese government bonds issued by the government. Due to the BoJ's market manipulation, Japanese government bond yields are at rock bottom levels. At press time, the current yield on 10-year Japanese government bonds is 0.77%. This financing cost is negligible.
On the asset side, the broadest breakdown is foreign securities. These are financial assets owned abroad by the public and private sectors. One large private holder of foreign assets is the Government Pension Investment Fund (GPIF). At $1.14 trillion, the fund is one of the largest pension funds, if not the largest, in the world. It owns foreign stocks, bonds, and real estate. Domestic loans, securities, and stocks also do well when the Bank of Japan sets bond prices. Finally, a weaker yen is the result of a large amount of yen debt, which pulls up domestic stock and real estate markets.
USD/JPY (white) rose, meaning the yen weakened against the dollar. The Nasdaq 100 (green) and Nikkei 225 (yellow) also rose.
Across the board, Japanese companies are taking advantage of the financial repression imposed by the Bank of Japan to fund themselves and earn high returns from the weak yen. This is why the Bank of Japan can continue to implement the loosest monetary policy in the world even as global inflation rises, which is simply a huge profit!
Source: GPIF
The GPIF has done even better in the last decade. What happened in the last decade was that the yen depreciated significantly. As the yen depreciated, the returns on foreign assets soared.
Source: GPIF
If not for the stellar returns on its foreign stock and bond portfolios, GPIF would have lost money last quarter. The domestic bond losses came as the Bank of Japan withdrew from YCC, which caused JGB yields to rise and prices to fall. However, the yen continued to weaken as the interest rate differential between the Bank of Japan and the Fed became wider than SBF's eyes when it found Emsam tablets, an antidepressant that SBF used regularly.
The deal for the Japanese companies is huge. Japan’s GDP is about $4 billion, the total exposure is a whopping 505%, and their value at risk is a whopping $24 billion. As Cardi B said, “I want you to park that big Mack truck in this little garage” (WAP lyrics). She’s definitely rapping about the Japanese men who planned this show in the “land of sunset.”
The trade obviously worked, but the yen got too weak. Earlier in July, the USD/JPY exchange rate was 162, which was too much to bear, as domestic inflation was and is rampant. The BoJ does not want to unwind this trade immediately, but rather slowly exit it over time...they always say that. Ueda succeeded Kuroda as BoJ Governor in April 2023, the chief architect of this massive trade. He got out while he could. Ueda was the only fool among the eligible candidates who wanted to kill himself by trying to unwind this trade. The market knew that Ueda would try to extricate the BoJ from the carry trade, so the question was always the pace of normalization.
Let out the wind
What would a disorderly unwinding of positions look like? What would happen to the various assets held by Japanese companies? How much would the yen appreciate? To unwind this trade, the Bank of Japan would need to raise interest rates by stopping its purchases of JGBs and eventually selling them back into the market.
What happens in terms of liability?
Without the BoJ’s constant suppression of JGB yields, it would rise as the market demands, with yields at least matching the rate of inflation. In June, Japan’s consumer price index (CPI) rose 2.8% year-on-year. If JGB yields rise to 2.8%, higher than any bond yield at any point on the yield curve, then the cost of debt of any maturity will increase. The interest costs of bond and treasury bill liabilities will surge. The BoJ will also have to raise interest on bank reserves to prevent these funds from escaping its clutches. Again, given the concepts involved, this cost will go from almost nothing to a huge cost.
In short, if interest rates were allowed to rise to market-clearing levels, the BoJ would have to pay billions of yen in interest every year to fund its position. Without any proceeds from the sale of assets on the books, the BoJ would have to print a lot of yen to keep its liabilities liquid. Doing so would make the situation worse; inflation would rise and the yen would depreciate. Therefore, they must sell assets.
On the asset side, what happens?
The biggest headache for the Bank of Japan is how to sell its vast stock of JGBs. Over the past two decades, the Bank of Japan has destroyed the JGB market through its various quantitative easing (QE) and yield curve control (YCC) programs. For all intents and purposes, that market no longer exists. The Bank of Japan must force another part of Japan's corporate sector to do its duty and buy JGBs at prices that will not cause the Bank of Japan to go bankrupt. When in doubt, ask the banks. Japanese commercial banks were forced to deleverage after the real estate and stock market bubbles burst in 1989. Bank lending has been paralyzed ever since. The Bank of Japan started printing money because businesses wouldn't borrow from the banks. Given the health of the banks, now is the time to put trillions of yen worth of JGBs back on their balance sheets.
While the Bank of Japan can have banks buy bonds, the banks need to get the money from somewhere else. As JGB yields rise, profit-seeking Japanese companies and banks holding trillions of dollars in foreign assets will sell those assets, repatriate the funds to Japan, and deposit them in banks. Banks and these companies will buy JGBs on a massive scale. The yen strengthens due to capital inflows, and JGB yields don't rise to a level that would cause the Bank of Japan to lose business while reducing its holdings.
Japanese companies sell foreign stocks and bonds to repatriate funds, and their main loss is the decline in the price of these stocks and bonds. Given the large scale of this carry trade, Japanese companies are the marginal price makers for stocks and bonds around the world. This is especially true for any securities listed in the United States, as the US market is the preferred destination for funding capital for yen carry trades. Given that the yen is a freely convertible currency, many TradFi trading books reflect the situation of Japanese companies.
As the yen weakens, more and more investors around the world are encouraged to borrow yen and buy U.S. stocks and bonds. Everyone is eager to cover their positions at the same time as the yen appreciates because they are highly leveraged. I showed you a chart earlier, what happens when the yen weakens? What happens if the yen strengthens slightly? Remember the early chart of USD/JPY going from 90 to 160 in 15 years? In 4 trading days, it went from 160 to 142, and this is what is happening:
A 10% appreciation of USD/JPY (white) causes a 10% decline in the Nasdaq 100 (white) and a 13% decline in the Nikkei 225 (green). The yen appreciation is roughly matched by the decline in the stock indexes at a 1:1 ratio. Extrapolating further, if USD/JPY were to reach 100, a 38% change, the Nasdaq would fall to ~12,600 and the Nikkei would fall to ~25,365.
USDJPY to 100 is possible, and a 1% reduction in Japanese corporate carry trades equates to about $240 billion in nominal terms. That’s a lot of money at the margin. Different players in Japanese corporates have different priorities. We saw this with Norinchubo, Japan’s fifth largest commercial bank. They were blown up in some of their carry trades and were forced to start unwinding their positions. They are selling foreign bond positions and taking forward USDJPY FX hedges. This was announced only a few months ago. Insurance companies and pension funds will be under pressure to disclose unrealized losses and exit trades. Alongside them are all the copiers who will be quickly liquidated by their brokers as currency and equity volatility rises. Remember, everyone is unwinding the same trade at the same time. Neither we nor the elites who run global monetary policy know the total size of the yen carry trade money positions lurking in the financial system. The opacity of this situation means that an overcorrection in the other direction will quickly follow as the market reveals this highly leveraged part of the global financial system.
Frightened
I believe that China and Japan have saved the United States from a worse recession since the 2008 global financial crisis. China has implemented one of the largest fiscal stimulus measures in human history in the form of debt-fueled infrastructure construction. China needs to buy goods and raw materials from the rest of the world to complete its projects. Japan has printed a lot of money through the Bank of Japan to expand its carry trade. Japanese companies use these yen to buy US stocks and bonds.
The U.S. government has generated a lot of revenue from capital gains taxes, a result of the stock market surge. From January 2009 to early July 2024, the Nasdaq 100 rose 16-fold and the S&P 500 rose six-fold. Capital gains tax rates range from about 20% to 40%.
The U.S. government is running deficits despite record high capital gains taxes. To finance the deficits, the Treasury must issue debt. Japanese companies are among the largest marginal buyers of Treasury bonds…at least until the yen starts to strengthen. The Japanese help make U.S. debt affordable for profligate politicians who need to buy votes with tax cuts (Republicans) or various forms of welfare checks (Democrats).
Total U.S. debt outstanding (yellow) has risen and moved to the right. However, the yield on the 10-year Treasury bond (white) has been range-bound, with little correlation to the growing debt.
My view is that the structure of the U.S. economy requires that Japanese companies and those that copy them continue to engage in this arbitrage trade. If this trade were to unwind, the U.S. government's finances would be torn to shreds.
Rescue Plan
The reason I speculate on a coordinated bailout of carry trade positions by Japanese companies is that I believe Harris will not have her candidacy weakened just because some local foreigner decided to exit some trade that she may not even understand. Her voters certainly don’t know what’s going on, and they don’t care. Their stock portfolios are either up or they aren’t. If not, they won’t come to vote for the Democrats on election day. Voter turnout will determine whether the clown emperor is Trump or Harris.
Japanese companies must close their positions, but cannot sell certain assets on the open market. This means that some US government agency must print money and lend it to some member of Japanese companies. Please allow me to reintroduce myself. My name is Central Bank Swap Agreement (CSWAP).
If I were “Bad Woman” Yellen, let me tell you how I would conduct the bailout. On Sunday evening, August 11, I would issue a communique (I’m pretending to be Yellen): “The U.S. Treasury, the Federal Reserve, and our counterparts in Japan had a lengthy conversation regarding the turbulent market conditions of the past week. During this call, I reiterated our support for the use of the U.S. dollar-yen central bank swap lines.”
That's it. To the public, it seems totally harmless. It's not that the Fed is throwing caution to the wind and making aggressive rate cuts and restarting quantitative easing statements. It's that the public knows that taking any of those steps would cause inflation, which is already uncomfortably high, to accelerate again. If inflation runs rampant on Election Day and can be easily traced back to the Fed, Harris will lose the election.
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, because of the way the mechanism is used, the market will rightly view it as a stealth bailout.
The Bank of Japan borrows billions of dollars and provides yen as collateral to the Fed. These swaps can be rolled over as many times as the Bank of Japan wants.
The Bank of Japan has privately spoken to large companies and banks, telling them that Japan 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 BoJ. These private entities holding USD repatriate capital to Japan by selling USD and buying JPY. They then buy JGBs from the BoJ at the current high prices/low yields. As a result, the outstanding CSWAPS has ballooned in size, and this USD amount is equivalent to the amount of money the Fed is printing.
I drew an ugly box and arrow diagram that helps illustrate the process. It's the net effect that's important.
The Federal Reserve -- they increased the supply of dollars, or in other words, they bought yen that had previously been generated by the growth of the carry trade.
CSWAP - The Fed owes the Bank of Japan dollars. The Bank of Japan owes the Fed yen.
Bank of Japan - They now hold more US stocks and bonds, the prices of these stocks and bonds will rise because the CSWAP balance is growing and the amount of dollars will also increase.
Bank of Japan - They now hold more Japanese government bonds.
As can be seen, the US stock and bond markets were not affected, and the total carry trade exposure of Japanese companies remained unchanged. The yen strengthened against the dollar, and most importantly, US stock and bond prices rose due to the Fed printing dollars. Another additional benefit was that Japanese banks could issue unlimited yen loans using the newly acquired Japanese government bond collateral. This trade breathed new life into the US and Japanese financial systems.
Timeline
I am sure the carry trades of Japanese companies will unwind. The question is when will the Fed and Treasury print money to undo the effects on the Pax Americana.
If the US stock market falls sharply on Friday (August 9), so that both the S&P 500 and the Nasdaq 100 are down 20% from their recent July all-time highs, some kind of action could be expected over the weekend. For the S&P 500, that level is 4533; for the Nasdaq 100, that level is 16540. I also expect the 2-year 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 bailout.
If the yen starts to weaken again, the crisis will be over in the short term. The unwinding will continue, albeit at a slower pace. I believe the market will go wild again between September and November as the USD/JPY moves back towards 100. There will definitely be a reaction this time as the US presidential election is only a few weeks or days away.
Trading in crypto is difficult. There are two opposing forces that influence my position on crypto.
Liquidity Positive Force: After a quarter of net restrictive policy, the U.S. Treasury will be a net injector of dollar liquidity as it will issue Treasury bills and potentially drain the Treasury General Account. This policy shift was spelled out in the recent Quarterly Repo Announcement. In short: Between now and the end of the year, the "bad woman" Yellen will inject between $301 billion and $1.05 trillion. I will explain this in a follow-up article if necessary.
Negative liquidity force: This is the appreciation of the yen. As yen debt becomes more expensive and must be repaid, the liquidation trade leads to a coordinated global sell-off of all financial assets.
Which force is stronger really depends on how quickly the carry trade is unwound. We can't predict that. The only observable effect is Bitcoin's correlation with USDJPY. If Bitcoin trades in a convex fashion, i.e. when USDJPY strengthens or weakens significantly, Bitcoin rises in both cases, then I know that if the yen is too strong and the liquidity provided by the US Treasury is sufficient, the market will expect a bailout. That's a 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. That's a correlated Bitcoin.
If the setup is convex bitcoin, I will aggressively add to my position as it reaches a local bottom. If the setup is correlated bitcoin, then I will sit on the sidelines and wait for the market to finally capitulate. The biggest assumption is that the Bank of Japan does not go the other way and cut the deposit rate to 0% and resume unlimited purchases of Japanese government bonds. If the Bank of Japan sticks to the plan it laid out at its last meeting, carry trade unwinding will continue.
This is as prescriptive as I can get for now. As always, these trading days and trading months will determine your gains in this bull run. If you must use leverage, use it wisely and constantly monitor your positions. When you have a leveraged position, you better take care of your Bitcoin or shitcoin. Otherwise, you will get liquidated.
It’s over, and I still have to enjoy the last part of my August vacation.
