Arthur Hayes: Bank of Japan's sell-off of US bonds helps drive new bull market for cryptocurrencies.

Original Title: Shikata Ga Nai

Original Author: Arthur Hayes

Original Compilation: Ismay, BlockBeats

Editor's note: Against the backdrop of global economic turmoil and financial market volatility, Hayes delves into the challenges faced by the Japanese banking system during the Federal Reserve's rate hike cycle, as well as the profound impact of US fiscal and monetary policies on the global market. Through a detailed analysis of the forex hedging strategy of the Norinchukin Bank and other Japanese commercial banks for US Treasury investments, the article reveals the reasons why these banks have to sell US Treasury bonds when the interest rate differential widens and forex hedging costs rise. Hayes further discusses the role of the FIMA repo mechanism and its impact on US-Japan financial relations, and predicts the crucial role this mechanism plays in maintaining market stability. The article ultimately calls on investors to seize investment opportunities in the current situation in the encryption market.

I just finished reading the first book of Kim Stanley Robinson's trilogy, "Red Mars". One of the characters in the book, the Japanese scientist Aiguo Hiroko, often says "shikata ga nai" when talking about situations that the Martian colonists cannot control, meaning "it can't be helped".

When I was thinking of a title for this 'short' article, this sentence came to mind. This article will focus on Japanese banks that have become victims of the 'Monetary Policy of America and Peace'. What have these banks done? In order to earn a good return on yen deposits, they have engaged in USD-JPY arbitrage trading. They borrowed from elderly depositors in Japan and found that almost all 'safe' government and corporate bonds in Japan had zero yield. Therefore, they concluded that borrowing money from the United States Treasury (UST) market for the 'Monetary Policy of America and Peace' was a better use of capital, as these bonds could bring higher returns even with fully hedged exchange rate risk.

However, when massive inflation in the United States due to cash bribes to the public to accept being locked at home and injected with experimental drugs to combat the 'baby boom flu', the Fed had to take action. The Fed raised interest rates at the fastest pace since the 1980s. As a result, it's bad news for anyone holding US government bonds. From 2021 to 2023, rising yields led to the worst bond sell-off since the War of 1812. Helpless!

In March 2023, the first wave of bank losses seeped through the underlying financial system. In less than two weeks, three major banks collapsed, leading the Fed to provide full support for all US Treasuries on the balance sheets of any US or foreign banks' branches in the US. As expected, Bitcoin saw a significant pump in the months following the rescue announcement.

Since the announcement of the bailout on March 12, 2023, Bitcoin has risen by more than 200%.

To solidify this roughly $4 trillion bailout (this is my estimate of the total amount of U.S. Treasuries and mortgage-backed securities held on U.S. banks' balance sheets), the Fed announced in March of this year that the use of the discount window was no longer a "kiss of death." If any financial institution needs a quick cash injection to fill a difficult hole on its balance sheet due to the "safe" government bond price falling, the window should be used immediately. What are we to say when the banking system inevitably bails out by devaluing the coins and undermining the dignity of human labor? Powerless!

The Fed did the right thing for American financial institutions, but what about foreigners who bought a large amount of US government bonds during the global liquidity surge from 2020 to 2021? Which country's banking balance sheet is most likely to be brought down by the Fed? Of course, it is the banking system of Japan.

The latest news shows that Japan's fifth largest bank will sell foreign bonds worth $63 billion, most of which are US Treasuries.

Japan Agricultural Bank will sell $63 billion US and European bonds

"Interest rates in the United States and Europe are rising, causing bond prices to fall. This has decreased the value of the high-priced (low-yield) foreign bonds purchased by Agricultural Bank of China in the past, leading to an expansion of its book losses."

Agricultural Bank of China Zhongjin was the first bank to capitulate and announce the need to sell bonds. All other banks are engaged in the same transaction, and I will explain this below. The Foreign Relations Committee provided us with an idea of the magnitude of the massive bond sales that Japanese commercial banks may sell.

According to the coordinated investigation by the International Monetary Fund (IMF) into portfolio investment, Japanese commercial banks held approximately $850 billion in foreign bonds in 2022. This includes nearly $450 billion in US Treasury bonds and about $75 billion in French bonds - a figure that far exceeds the bonds issued by other major eurozone countries they hold.

Why is this important? Because Yellen will not allow these bonds to be sold on the open market and cause a surge in US Treasury yields. She will require the Bank of Japan (BOJ), supervised by the Japanese Central Bank, to purchase these bonds. Then, the BOJ will 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 US Treasury securities and obtain freshly minted US dollars overnight.

The increase in the FIMA repurchase mechanism indicates an increase in the liquidity of the US dollar in the global currency market. Everyone knows what this means for Bitcoin and cryptocurrencies... That's why I think it's necessary to remind readers about another hidden way of printing money. This is how I understood how Yellen prevented these bonds from entering the public market after reading a dry Atlanta Fed report called 'Offshore Dollars and US Policy'.

Why now

The Fed signaled in late 2021 that it would begin raising policy rates in March 2022, from which point US Treasuries (USTs) began to collapse. Why would a Japanese bank choose to confirm its losses now, after more than two years of pain? Another strange fact is that, according to the consensus view of economists you should listen to, the US economy is on the edge of recession. Therefore, the Fed may cut interest rates after several meetings. Rate cuts will push up bond prices. Since all the "smart" economists tell you that relief is just around the corner, why sell now?

The reason is that AgriBank's forex hedging purchase of US Treasury bonds has changed from a slight positive yield to a significant negative yield. Before 2023, the interest rate differential between the US dollar and the Japanese yen was negligible. Then, the Federal Reserve diverged from the Bank of Japan (BOJ) by raising interest rates, while BOJ maintained a -0.1% interest rate. As the gap widened, the cost of hedging the US dollar risk embedded in US Treasury bonds exceeded the higher yield.

The operation principle is as follows. Nokyo-Chukin Bank is a Japanese bank that holds yen deposits. If it wants to buy higher-yielding US Treasury bonds, it must pay in US dollars. Nokyo-Chukin Bank will sell yen today and buy US dollars to purchase bonds; this is done in the spot market. If Nokyo-Chukin Bank only does this step, and the yen appreciates before the bonds mature, Nokyo-Chukin Bank will lose money when selling the US dollars back to yen. For example, if you buy US dollars at USDJPY 100 today and sell US dollars at USDJPY 99 tomorrow; the US dollar depreciates and the yen appreciates. Therefore, Nokyo-Chukin Bank usually sells US dollars and buys yen in the three-month forward market to hedge this risk. It will roll over every three months until the bonds mature.

Usually, three-month forward contracts have the highest liquidity. That's why banks like AgBank use rolling three-month forward contracts to hedge currency purchases for ten years.

As the interest rate differential between the US dollar and the Japanese yen widens, the forward points become negative because the policy interest rate of the Federal Reserve is higher than that of the Bank of Japan. For example, if the spot USDJPY is 100 and the US dollar's yield is 1% higher than the yen's yield in the future year, then the forward price of USDJPY for one year should be around 99. This is because if I borrow 10,000 yen today at 0% interest rate to buy 100 US dollars, and then deposit the 100 US dollars to earn 1% interest, I will have 101 US dollars after one year. What should be the forward price of USDJPY for one year to offset this 1 US dollar interest income? It's about 99 USDJPY, which is the no-arbitrage principle. Now imagine that I did all this just to buy a US bond with a yield only 0.5% higher than similar maturity Japanese government bonds (JGB). In fact, I paid a negative yield of 0.5% in this trade. If this is the case, Norinchukin or any other bank would not make this deal.

Returning to the chart, as the spread widens, the forward points for the three-month period become so negative that the yield on US Treasury bonds hedged back to the yen is lower than that of Japan's yen-denominated government bonds directly purchased. From mid-2022, you will see the red line representing the US dollar below the 0% on the X-axis. Please note that the Bank of Japan, which purchases yen-denominated government bonds, has no currency risk and therefore no reason to pay hedging costs. The only reason for this transaction is when the yield after forex hedging is greater than 0%.

The situation of AgBank's participation in the long side is worse than that of FTX/Alameda. From the perspective of market capitalization, the US Treasury bonds purchased in 2020-2021 may have dropped by 20% to 30%. In addition, the forex hedging cost has increased from negligible to over 5%. Even if AgBank believes that the Fed will lower interest rates, a 0.25% rate cut is not enough to reduce hedging costs or boost bond prices to stop the bleeding. Therefore, they must sell US Treasury bonds.

Any plan that allows AgriBank to exchange US Treasury bonds for new US dollars cannot solve the cash flow problem. From the perspective of cash flow, the only thing that can restore profitability to AgriBank is a significant narrowing of the policy interest rate gap between the Federal Reserve and the Bank of Japan. Therefore, any plan of the Federal Reserve, such as a permanent repurchase agreement mechanism, that allows the US branches of foreign banks to repurchase US Treasury bonds and mortgage-backed securities in exchange for newly printed US dollars is ineffective in this case.

As I write this article, I'm racking my brain to think of any other financial instrument that could help AgBank avoid selling bonds. But as mentioned above, existing plans are some form of loan and swap. As long as AgBank holds bonds in any form, currency risk still exists and must be hedged. It is only after the bonds are sold that AgBank can unwind the forex hedge, which is a huge cost for it. That's why I believe AgBank's management has explored all other options and selling bonds is the last resort.

I will explain why Yellen is dissatisfied with the situation, but now, let's shut down Chat GPT and use our imagination. Is there a Japanese public institution that can purchase bonds from these banks and bear the risk of bankruptcy in dollars without fear?

Ding dong

Who's there?

It is the Central Bank of Japan.

Rescue Mechanism

The Bank of Japan (BOJ) is one of the few central banks that can use the FIMA repurchase mechanism. It can hide the price discovery of US Treasury bonds by:

The Central Bank "gently advises" any Japanese commercial bank that needs to sell US government bonds to sell these bonds directly onto the Central Bank's balance sheet, rather than selling them on the open market and settlement at the current last traded price, with no impact on the market. Imagine that you could dump all your FTT Token at market price because Carolyn Allison is there to support the market and can provide support of any necessary size. Obviously, this doesn't work well for FTX, but she's not a central bank with a money printing machine. Her money printing machine can only handle $10 billion in client money, while the Central Bank of Japan handles unlimited.

Then, the Bank of Japan uses the FIMA repurchase mechanism to exchange US Treasury bonds for US dollars printed out of thin air by the Federal Reserve.

One, two, tie your shoelaces. It's that simple to bypass the free market. Buddy, this is a freedom worth fighting for!

Let's ask a few questions to understand the impact of this policy.

Someone has to lose money here; the bond losses caused by the rise in interest rates still exist. Who is the scapegoat?

The Bank of Japan will still incur losses by selling bonds to the Bank of Japan at current market prices. The Bank of Japan is now taking on the future risk of U.S. Treasury bond maturities. If the price of these bonds falls, the Bank of Japan will have unrealized losses. However, this is the same risk that the Bank of Japan currently faces on its tens of trillions of yen-scale Japanese government bond portfolio. The Bank of Japan is a quasi-governmental entity, will not go bankrupt, and does not need to comply with capital adequacy requirements. It also does not have a risk management department to forcibly reduce positions when the Value-at-Risk (VaR) is forced to reduce positions due to the huge rise in DV01 risk.

As long as the FIMA repurchase mechanism exists, the Bank of Japan can roll over repurchases every day and hold US Treasury bonds until maturity.

How is the supply of US dollars increasing?

The repurchase agreement requires the Federal Reserve to provide dollars to the Bank of Japan in exchange for US Treasury bonds. This loan rolls over every day. The Federal Reserve obtains these dollars through its printing presses.

We can monitor the injection of dollars into the system on a weekly basis. The name of the project is "Repurchase Protocol - Foreign Official".

As you can see, FIMA repurchase is currently very small. But the sell-off has not yet begun, and I think there will be some interesting phone conversations between Yellen and BOJ Governor Kuroda. If I'm not mistaken, this number will increase.

Why help others

Americans are not known for their sympathy towards foreigners, especially those who do not speak English and have strange appearances. Appearance is relative, but for the farmers in Flying Over State who are tanned and waving Confederate flags, Japanese people just don't look right. And do you know what? These uncultured people will decide who the next emperor is in November this year. It's really speechless.

Despite the potential xenophobia, the reason Yellen will extend a helping hand is because, if there are no new dollars to absorb these junk bonds, all of the major Japanese banks will follow Nomura's lead and sell their US Treasury bond portfolios to ease the pain. This would mean that $450 billion worth of US Treasuries would quickly flood the market. This cannot be allowed, as yields would skyrocket, making federal financing very expensive.

As the Fed itself said, this is why the FIMA repo facility was created:

During the 'cash grab' period in March 2020, the central bank simultaneously sold US Treasury bonds and deposited the proceeds in overnight repurchase agreements with the New York Fed. In response, the Fed proposed at the end of March to provide the central bank with overnight loans using US Treasury bonds held in custody at the New York Fed as collateral, at a higher interest rate than private repurchase rates. This loan would allow the central bank to raise cash without being forced to sell completely in a tight Treasury market.

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

I am very confident that in the election year, when her boss faces the threat of being defeated by the Orange Man (referring to Trump), Yellen will fulfill her 'democratic' responsibility to ensure that yields remain low to avoid a financial market disaster. In this case, all Yellen needs to do is call Uptown and instruct him not to allow the Bank of Japan to sell US government bonds in the open market, but to use the FIMA repurchase mechanism to absorb the supply.

Trading Strategy

Everyone is closely following when the Federal Reserve will finally start cutting interest rates. However, the interest rate differential between the US dollar and the Japanese yen is +5.5% or 550 basis points, equivalent to 22 rate cuts (assuming the Fed cuts rates by 0.25% at each meeting). Over the next twelve months, one, two, three, or four rate cuts will not significantly reduce this difference. In addition, the Bank of Japan has shown no willingness to raise policy rates. At most, the Bank of Japan may reduce the pace of open market bond purchases. The reason why Japanese commercial banks must sell their forex hedged US Treasury bond investments has not been resolved.

This is why I am confident in accelerating the pace of transferring from Ethena's stake in USD (sUSDe), which currently earns a profit of 20-30%, to encrypted risk assets. Given this news, the pain has reached a point where the Bank of Japan has no choice but to exit the US Treasury market. As I mentioned, in an election year, the ruling Democratic Party least needs a sharp rise in US Treasury yields, as this would affect the main financial issues that the median voter is most concerned about, namely mortgage rates, credit card rates, and auto loan rates. If Treasury yields rise, these rates will also rise.

This is exactly why the FIMA repurchase mechanism was established. All that is needed now is for Yellen to firmly demand that the Bank of Japan use it.

Just as many people are starting to wonder where the next liquidity shock to the US dollar will come from, the Japanese banking system has delivered a brand new dollar made up of origami cranes to crypto investors. This is just another pillar of the crypto bull market. In order to sustain the current dollar-based, corrupt financial system of the United States of America, the supply of dollars must increase.

Say with me, 'Shikata ga nai', and then Buy the Dips!

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