Author: Arthur Hayes

Compiled by Ismay, BlockBeats

Editor's note: Against the backdrop of global economic turmoil and financial market fluctuations, Hayes delves into the challenges faced by the Japanese banking system during the Fed's rate-hike cycle, as well as the far-reaching impact of U.S. fiscal and monetary policies on global markets. Through a detailed analysis of forex hedging strategies for U.S. Treasury investments by Japan's Norinchukin Bank and other Japanese commercial banks, the article reveals the reasons why these banks have had to sell U.S. Treasuries as interest rate differentials widen and forex hedging costs rise. Hayes further discusses the role of the FIMA repo mechanism and its impact on U.S.-Japan financial relations, and predicts the key role of this mechanism in maintaining market stability. The article ultimately calls on investors to seize investment opportunities in the encryption market in the current situation.

I just finished reading the first book in Kim Stanley Robinson's trilogy, "Red Mars". In the book, a character named Hiroko Ai frequently says "仕方がない" when referring to the situation that Mars colonists cannot control, which means "nothing can be done".

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

However, when massive inflation hit the United States due to cash bribes paid to the public to accept being locked up at home and injected with experimental drugs to fight the 'baby flu', the Fed had to act. It raised interest rates at the fastest pace since the 1980s. The result was bad news for anyone holding US Treasuries. From 2021 to 2023, rising yields led to the worst bond round since the War of 1812. Helpless!

In March 2023, the losses of the first batch of banks leaked through the underlying financial system. Within less than two weeks, three major banks collapsed, leading the Federal Reserve to provide comprehensive support for all US Treasury bonds on the balance sheets of any US or foreign banks' branches in the US. As expected, Bitcoin experienced a significant pump in the months following the announcement of the bailout.

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

In order to consolidate the approximately $4 trillion rescue plan (which is my estimate of the total amount of U.S. Treasury bonds and mortgage-backed securities held on the balance sheet of Bank of America), the Fed announced in March of this year that the use of the discount window is no longer a 'kiss of death'. If any financial institution needs to inject cash quickly to fill the difficult-to-handle gaps on its balance sheet caused by the falling prices of 'safe' government bonds, it should immediately use this window. When the banking system inevitably rescues itself through currency devaluation and undermines the dignity of human labor, what can we say? Helpless!

The Fed did the right thing for US financial institutions, but what about foreigners who bought a lot of US treasuries during the global surge in funds from 2020 to 2021? Which country's bank balance sheet is most likely to be broken by the Fed? Of course, it is Japan's banking system.

The latest news shows that the fifth largest Japanese bank will sell foreign bonds worth $63 billion, most of which are US Treasury bonds.

The Japan Agricultural, Forestry and Fisheries Finance Corporation will sell $63 billion in US and European bonds

"The rise in interest rates in the United States and Europe has led to a drop in bond prices. This has reduced the value of the high-priced (low-yielding) foreign bonds previously purchased by Agriculture and Forestry Bank, resulting in an expansion of its book losses."

Agriculture Bank of China was the first bank to cave and announce that it must sell bonds. All other banks are engaged in the same transaction, and I will explain this below. The Foreign Relations Committee provided us with a concept of the scale of the huge bond sales that Japanese commercial banks may sell.

According to the coordinated survey on portfolio investment by the International Monetary Fund (IMF), Japanese commercial banks held approximately $850 billion in foreign bonds in 2022. This includes nearly $450 billion in U.S. bonds and approximately $75 billion in French bonds - a figure that far exceeds the bonds issued by other major countries in the euro area that 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 demand that the Bank of Japan (BOJ) supervised by the Japanese Central Bank (BOJ) buy these bonds. Then, the BOJ will use the Foreign and International Monetary Authorities (FIMA) repurchase mechanism established by the Fed in March 2020. The FIMA repurchase mechanism allows central bank members to pledge US Treasury bonds and obtain newly printed 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. It wasn't until I read a dry Atlanta Fed report called 'Offshore Dollars and US Policy' that I understood how Yellen prevents these bonds from entering the public market.

Why now

The Federal Reserve sent a signal at the end of 2021 that it would start raising policy rates in March 2022, and since then, US Treasuries (USTs) have started to collapse. It has been over two years, so why would a Japanese bank choose to acknowledge its losses now after going through 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 brink of recession. Therefore, the Fed may cut interest rates after several meetings. Interest rate cuts will boost bond prices. Since all the 'smart' economists tell you that relief is just around the corner, why sell now?

The reason is that AgBank's forex hedging purchase of US Treasuries has changed from slightly positive yields to significantly negative yields. Until 2023, the interest rate differential between the US dollar and the Japanese yen was minimal. Then, the Fed diverged from the Bank of Japan (BOJ) by raising interest rates, while the BOJ stuck to a -0.1% interest rate. As the gap widened, the cost of hedging the dollar risk embedded in US Treasuries exceeded the higher yield.

The operation principle is as follows. Nonglin Zhongjin Bank is a Japanese bank that holds yen deposits. If it wants to purchase US Treasury bonds with higher yields, it must pay in US dollars. Nonglin Zhongjin Bank sells yen today and buys US dollars to purchase bonds; this is done in the spot market. If Nonglin Zhongjin Bank only does this step and the yen appreciates before the bonds mature, Nonglin Zhongjin 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 them at USDJPY 99 tomorrow; the US dollar depreciates and the yen appreciates. Therefore, Nonglin Zhongjin Bank usually sells US dollars and buys yen in the three-month forward market to hedge this risk. It rolls over every three months until the bonds mature.

Usually, three-month forward contracts are the most liquid. That's why banks like Agroforestry Bank use rolling three-month forward contracts to hedge their 10-year currency purchases.

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 yield of the US dollar is 1% higher than the yen in the next 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 approximately 99 USDJPY, which is the no-arbitrage principle. Now, imagine I did all this just to buy a US government bond with a yield only 0.5% higher than a similar maturity Japanese government bond (JGB). In fact, I paid a negative yield of 0.5% in this transaction. In this case, Norinchukin or any other bank would not conduct this transaction.

Returning to the chart, as the spread widens, the three-month forward points become so negative that the hedged US Treasury yields in yen fall below the direct purchase of yen-denominated Japanese government bonds. From mid-2022, you will see the red line representing the US dollar fall below 0% on the X-axis. Remember, the Bank of Japan faces no currency risk in buying yen-denominated Japanese government bonds, so there is no reason to pay for hedging. The only reason for this trade is when the yield after forex hedging is >0%.

The situation of Agricultural Bank of China is worse than that of the bulls on 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 hedging cost for forex has increased from negligible to over 5%. Even if Agricultural Bank of China believes that the Federal Reserve will cut 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 mortgage US treasuries for new US dollars will not solve the cash flow problem. From a cash flow perspective, the only thing that can restore AgriBank's profitability is a significant narrowing of the policy interest rate gap between the Federal Reserve and the Bank of Japan. Therefore, any plan by the Federal Reserve, such as a permanent repurchase agreement, that allows foreign banks' US branches to repurchase US treasuries and collateralized loans to support securities in exchange for newly printed US dollars is ineffective in this scenario.

When I wrote this article, I racked my brains to think of any other financial means to enable AgriBank to avoid selling bonds. But as mentioned above, existing plans are some form of loans and swaps. As long as AgriBank holds bonds in any form, currency risk still exists and must be hedged. Only after the bonds are sold can AgriBank unwind the forex hedge, which is a huge cost for it. This is why I believe the management of AgriBank has explored all other options, and selling bonds is the last resort.

I will explain why Yellen is unhappy with this situation, but for now, let's turn off Chat GPT and use our imagination. Is there a Japanese public institution that can buy bonds from these banks and bear the risk of USD interest rates without fear of bankruptcy?

Dingdong

Who's there?

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 through the following methods:

The Bank of Japan 'mildly suggests' any Japanese commercial bank that needs to sell US Treasury bonds to directly sell these bonds to the balance sheet of the Bank of Japan, instead of selling them on the open market, and settle at the current last transaction price, without affecting the market. Imagine being able to sell all FTT tokens at market price, because Caroline Allison supports the market there and can provide support of any necessary scale. Obviously, this is not effective for FTX, but she is not the central bank with a printing press. Her printing press can only handle $10 billion in customer funds, while the Bank of Japan handles an unlimited amount.

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 would still recognize losses by selling bonds to the Bank of Japan at current market prices. The Bank of Japan is now taking on the future maturity risk of US Treasuries. If the prices of these bonds fall, 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 of Japanese government bond holdings. The Bank of Japan is a quasi-governmental entity, does 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) rises 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 they mature.

How is the supply of USD increased?

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 daily. The Federal Reserve obtains these dollars through its printing press.

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

As you can see, the FIMA repurchase is currently very small. But the sell-off has not started yet, 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 cannot speak English and have a strange appearance. Appearance is relative, but to the farmers tanning in Flyover State, waving Confederate flags, the Japanese look odd. And you know what? These uncultured people will decide who the next emperor is in November this year. It's just speechless.

Despite the underlying xenophobic sentiment, the reason Yellen will still lend a helping hand is that without new U.S. dollars to absorb these junk bonds, all major Japanese banks will follow the footsteps of Nomura and sell off their U.S. Treasury portfolios to alleviate the pain. This means that $450 billion worth of U.S. Treasuries will quickly enter the market. This cannot be allowed because yields will skyrocket, making financing for the federal government very expensive.

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

"During the 'cash grab' in March 2020, the central bank sold US Treasuries and deposited the proceeds in overnight repurchase agreements at the New York Fed. In response, the Fed proposed at the end of March to provide the central bank with overnight loans using US Treasuries held in custody at the New York Fed as collateral, at a rate higher than the private repo rate. This loan would allow the central bank to raise cash without being forced to conduct a full sale in an already tense Treasury market."

Do you remember September to October 2023? During those two months, the yield curve of U.S. Treasury bonds steepened, causing the S&P 500 index to fall by 20%, and the yields on 10-year and 30-year U.S. Treasury bonds exceeded 5%. In response, Yellen shifted most of the debt issuance to short-term Treasury bills to drain cash from the Fed's reverse repo program. This boosted the market, and from November 1st, all risk assets, including cryptocurrencies, started 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) in crime, Yellen will fulfill her responsibility to 'democracy' and ensure that the yield remains low to avoid a financial market disaster. In this case, all Yellen needs to do is call Ueda and instruct him not to allow the Bank of Japan to sell US Treasury bonds on the open market, but to use the FIMA repurchase mechanism to absorb the supply.

Trading Strategies

Everyone is closely following when the Fed 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). One, two, three or four rate cuts within the next twelve months will not significantly narrow this gap. 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 its open market purchases of bonds. The reason why Japanese commercial banks must sell their hedged US Treasury portfolio investments has not been resolved.

This is why I am confident in accelerating the pace of transferring from Ethena stake USD (sUSDe), currently earning 20-30% interest, to encrypted risk assets. Given this news, the pain has reached the point where Japanese banks have no choice but to exit the US Treasury market. As I have stated, in an election year, the last thing the ruling Democratic Party needs is a significant rise in US Treasury yields, as this would affect the major financial issues most concerning to the median voter, namely mortgage interest rates, credit card, and car loan rates. If the yield on Treasury bonds rises, all these rates will rise.

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

Just when long began to wonder where the next dollar Liquidity shock would come from, the Japanese banking system sent encryption investors a brand new dollar made up of origami cranes. This is just another pillar of the encryption Bull Market. In order to maintain the current dollar-based America and a peaceful and dirty financial system, the dollar supply must increase.

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