lefterisjp | Pingpad

What do you do when the market is down but you are going to win an election?

If you are a politician, the answer to this question is simple. Your primary goal is to secure reelection. So you print money and manipulate prices to go up.

Imagine you are Kamala Harris, the Democratic candidate for the US presidency, facing the powerful Orange Man. You need everything to go right because a lot of things have gone wrong since the last time 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 is Obama’s puppet, I bet he is warning her about how bad the 2008 global financial crisis would have been if it had come to her doorstep a few months before the election. US President Joe Biden is working in his vegetable patch, so people think Harris is in control.

In September 2008, Lehman Brothers went bankrupt, triggering a true global financial crisis, just as George W. Bush was finishing his second term as president. Given that he was a Republican president, one could argue that part of Obama’s appeal as a Democrat was that he was a member of another party and therefore not responsible for the recession. Obama won the 2008 presidential election.

Let’s refocus on Harris’ dilemma: how to respond to a global financial crisis triggered by the unwinding of Japan’s massive yen carry trade. She can let it run its course and let the free market destroy over-leveraged businesses and let wealthy baby boomer financial asset holders experience some real pain. Or, she can instruct U.S. Treasury Secretary bad girl Yellen to fix the problem by printing money.

Like any politician, regardless of party affiliation or economic beliefs, Harris will instruct Yellen to use the monetary tools at her disposal to avert a financial crisis. Of course, that means the printing presses will start rolling in some way, shape, or form. Harris doesn’t want Yellen to wait—she wants Yellen to act forcefully and immediately. So if you agree with me that the unwinding of the yen carry trade could cause the entire global financial system to collapse, you also have to believe that Yellen will act no later than the opening of Asian trading next Monday (August 12).

To give you a sense of the size and magnitude of the potential impact of the unwinding of the Japanese corporate carry trade, I’ll walk through an excellent research note from Deutsche Bank in November 2023. I will then describe how I would formulate a bailout plan if I were appointed head of the U.S. Treasury.

Why does Japan always stick to the loosest monetary policy?

What is a carry trade? A carry trade is borrowing one low-interest currency and then exchanging it for another currency to buy a financial asset with a higher yield or a higher probability of appreciation. When the loan needs to be repaid, the funds lose if the borrowed currency appreciates relative to the currency of the asset purchased. If the borrowed currency depreciates, the funds make money. Some investors hedge currency risk, while some do not. In this case, Japanese companies do not need to hedge their borrowed yen because the Bank of Japan can print an unlimited amount of yen.

Japanese companies refer 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 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 explode and drag down the Japanese economy?" The situation today is very different from the end of last year.

The storyline is that Japan is heavily in debt. Hedge fund bros are betting on Japan’s impending collapse. But those who bet on Japan always lose. Many macro investors are too bearish on Japan because they don’t understand Japan’s combined public and private balance sheets. This is an easy psychological mistake for Western investors who believe in individual rights. But in Japan, the collective reigns supreme. Therefore, certain actors that are considered private in the West are simply substitutes for government.

Let's deal with the liabilities side first. These are the sources of funding for the carry trade. Yen is borrowed this way. 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 with the BoJ. This amount is large because the BoJ creates bank reserves when it buys bonds. Remember that the BoJ owns nearly half of the Japanese government bond market. So the amount of bank reserves is very large, at 102% of GDP. These reserves cost 0.25%, which the BoJ pays to the banks. For reference, the Fed pays 5.4% for 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 BoJ's market manipulation, Japanese government bond yields are at rock bottom levels. As of the time of this posting, the current 10-year Japanese government bond yield is 0.77%. This financing cost is negligible.

On the asset side, the broadest item is foreign securities. These are financial assets owned abroad by the public and private sectors. One of the large private holders of foreign assets is the Government Pension Investment Fund (GPIF). With $1.14 trillion in assets, it is one of the largest pension funds in the world, if not the largest. It owns foreign stocks, bonds, and real estate.

When the Bank of Japan prices bonds, domestic loans, securities, and stocks also do well. Finally, the depreciation of the yen, due to the large amount of yen debt created, pushes up domestic stock and real estate markets.

USD/JPY (white) is rising, which means the yen is weakening against the dollar. The Nasdaq 100 (green) and Nikkei 225 (yellow) are also rising.

Overall, Japanese companies are taking advantage of the financial repression policies implemented by the Bank of Japan to finance themselves and are highly rewarded by 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. It's really profitable.

The GPIF has done well, especially in the last decade, when the yen has depreciated significantly. As the yen has depreciated, the returns on foreign assets have risen significantly.

The GPIF would have lost money last quarter if it weren’t for the stellar returns on its overseas equity and bond portfolios. The domestic bond losses were because the BoJ exited YCC, which sent JGB yields higher and prices lower. Yet the yen continued to weaken as the spread between the BoJ and the Fed got wider than Sam Bankman-Fried’s eyes when he discovered the Emsam pill.

Japanese companies were in a massive trade. With a total exposure of 505% of Japan’s GDP at about $4 trillion, they were taking on a $24 trillion value at risk. As Cardi B said, “I hope you park that big Mack truck in this little garage.” She must have been rapping about the Japanese men who were in power in the land of sunset.

The trade obviously worked, but the yen got too weak. At the beginning of July, USD/JPY was 162, which was too much to bear as domestic inflation was then and now raging.

The BoJ didn’t want to stop the trade immediately, but rather wanted to slowly exit it over time…they always say that. Takashi Ueda succeeds Takashi Kuroda as BoJ governor in April 2023, who was the main architect of this massive trade. He took advantage of the opportunity to exit. Takashi Ueda is the only fool left among the qualified candidates who wanted to commit seppuku by trying to unwind this trade. The market knew that Takashi Ueda would try to get the BoJ out of this carry trade. The question is always the speed of normalization.

The BoJ'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 its positions, the BoJ would need to raise interest rates by stopping its purchases of JGBs and eventually selling them back to the market.

On the liability side, what would happen?

If the BoJ hadn't been constantly pushing down JGB yields, they would rise as the market demanded, with yields at least matching inflation. Japan's consumer price index (CPI) rose 2.8% year-on-year in June. If JGB yields rise to 2.8%, higher than any bond yield at any point on the yield curve, the cost of debt of any maturity would increase. The interest costs on the bond and treasury bill liability items would surge.

The BoJ would also have to raise interest on bank reserves to prevent those funds from escaping its clutches. Again, that cost would rise from near zero to huge, given the notional amounts involved.

In short, if interest rates were allowed to rise to market-clearing levels, the BoJ would have to pay billions of yen in interest each year to maintain its position. Without revenue from asset sales on the other side of the book, the BoJ would have to print huge amounts of yen to keep its debt serviced. Doing so would make the situation worse; inflation would rise and the yen would fall. So, assets must be sold.

On the asset side, what would happen?

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, the JGB market no longer exists. The Bank of Japan must force another member of Japanese corporate to do its job and buy JGBs at prices that will not bankrupt the Bank of Japan.

Japanese commercial banks were forced to deleverage after the real estate and stock market bubbles burst in 1989. Bank lending has been stagnant ever since. The Bank of Japan began printing money because corporates were not borrowing from the banks. Given that the banks are in good shape, now is the time to put a few quadrillion yen worth of JGBs back on its balance sheet.

While the Bank of Japan can tell banks to buy bonds, the banks need to move the capital somewhere. As JGB yields rise, profit-seeking Japanese corporates and banks holding trillions of dollars in overseas assets will sell those assets, repatriate the capital to Japan, and deposit them in banks. Banks and these businesses will buy JGBs in large quantities. As a result of the capital inflows, the yen appreciates, and JGB yields do not rise to levels that would bankrupt the Bank of Japan when it reduces its holdings.

The biggest loss is the fall in the prices of foreign stocks and bonds that Japanese companies sell to generate capital repatriation. Given the sheer size of this carry trade, Japanese companies are the marginal price makers for stocks and bonds around the world. This is especially true for any US-listed securities, as their markets are the preferred destination for funding capital for yen carry trades. Given that the yen is a freely convertible currency, many TradFi trading books reflect Japanese companies.

As the yen depreciates, more and more investors around the world are encouraged to borrow yen and buy US stocks and bonds. Because leverage is high, as the yen appreciates, everyone will rush in at the same time.

I showed you a chart earlier showing what happens when the yen depreciates. What happens when it appreciates a little bit? Remember the earlier chart showing the USD/JPY falling from 90 to 160 in 15 years? In 4 trading days, it fell from 160 to 142, as follows:

S0I5IZmQxBXdqIsXXdV7o2zhSTYy1QkzXZBE9sBl.jpeg

A 10% increase in USD/JPY (white) resulted in a 10% decrease in the Nasdaq 100 (white) and a 13% decrease in the Nikkei 225 (green). The percentage increase in the yen was about 1:1 to the decrease in the stock index. Extrapolating further, if USD/JPY reached 100, a 38% increase, the Nasdaq would fall to about 12,600 and the Nikkei would fall to about 25,365.

A 100 USD/JPY increase is possible. A 1% decrease in Japanese corporate carry trades is equivalent to about $240 billion in notional value. This is a huge amount of capital at the margin. Different players in Japanese corporates have different secondary priorities. We saw this with Norinchubo, Japan’s fifth largest commercial bank. Their carry trade section went bust and they were forced to start unwinding their positions. They were selling foreign bond positions and covering forward USD/JPY FX hedges. This announcement was made only a few months ago. Insurance companies and pension funds will be under 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 who manage global monetary policy know the total size of the yen carry trade financing positions hidden in the financial system. The opacity of the situation means that an overcorrection will quickly occur in the other direction as markets gradually reveal this highly leveraged part of the global financial system.

2008 Global Financial Crisis Shock

Why does bad girl Yellen care?

Since the 2008 Global Financial Crisis, I think China and Japan have saved Pax Americana from a worse recession. China has undertaken one of the largest fiscal stimulus measures in human history, expressed through debt-fueled infrastructure construction. China needs to buy goods and raw materials from the rest of the world to complete the projects. Japan has printed huge amounts of money through the Bank of Japan to increase its carry trade. Japanese companies have used these yen to buy US stocks and bonds.

The US government has received significant revenue from capital gains taxes, which are the result of soaring stock markets. From January 2009 to early July 2024, the Nasdaq 100 has risen 16 times and the S&P 500 has risen 6 times. Capital gains tax rates are around 20% to 40%.

Despite record capital gains taxes, the US government is still running a deficit. To finance the deficit, the US Treasury must issue bonds. Japanese companies are one of the largest marginal buyers of US Treasuries…at least until the yen starts to appreciate. Japan helps afford US debt to profligate politicians who need to buy votes with tax cuts (Republicans) or various forms of welfare checks (Democrats).

My view is that the structure of the U.S. economy requires that Japanese companies and their imitators continue to engage in this carry trade. If this trade ends, the U.S. government's finances will be in tatters.

Bailout

My assumption of a coordinated bailout of Japanese corporate carry trade positions is based on the belief that Harris will not allow her electoral chances to weaken because some foreigners decided to exit some trade that she may not even understand. Her voters certainly don't know what's going on and don't care. Their stock portfolios are either up or they're not. If not, they won't show up on Election Day to vote for the Democrats. Turnout will determine whether the clown emperor is Trump or Harris.

Japanese companies must unwind their positions, but they cannot sell some assets on the open market. This means that some government agency in the United States must print money and lend it to certain members of Japanese companies. Please allow me to reintroduce myself. My name is Central Bank Swaps (CSWAP).

How would I conduct a bailout if I were bad girl Yellen?

On Sunday evening, August 11, I will issue a communique (I am speaking as Yellen):

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

That’s it. To the public, it seems completely harmless. It’s not a statement that the Fed will cave in and do aggressive rate cuts and restart quantitative easing. It’s because the public knows that doing any of those things will cause already uncomfortably high inflation to accelerate again. If inflation runs rampant on Election Day and can be easily traced back to the Fed, Harris will lose.

Most American voters have no idea what the CSWAP is, why it was created, or how it can be used to print unlimited amounts of money. Yet the market will rightly view this as a stealth bailout because of what the facility will be used for.

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

The Bank of Japan privately talks to large companies and banks, telling them that 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 own large amounts of dollars and repatriate that capital to Japan by selling dollars and buying yen. They then buy JGBs from the BoJ at the current high prices/low yields. The result is an inflated CSWAPS outstanding, and this dollar amount is similar to the amount of money the Fed is printing.

I created an ugly box and arrow plot that will help illustrate the process.

The net effect is what matters.

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Fed – they increase the supply of dollars, in other words, in return they get the yen that was previously generated by the growth of the carry trade.

CSWAP – the BoJ owes the Fed dollars. The Fed owes the BoJ yen.

BoJ – they now hold more US stocks and bonds, which will rise in price due to the rising dollar amount due to the growing CSWAP balance.

Bank of Japan – they now hold more JGBs.

As you can see, there is no impact on US stock or bond markets, and the total carry trade risk for Japanese companies remains the same. The yen appreciates against the dollar, and most importantly, US stock and bond prices rise due to the Fed printing dollars. The added bonus is that the Bank of Japan can issue unlimited yen-denominated loans against the newly acquired JGB collateral. This trade re-inflates both the US and Japanese systems.

Cryptocurrency Trading Advice

The carry trades of Japanese companies will unwind; of this, I am sure. The question is when the Fed and Treasury will print money to mitigate its impact on Pax Americana.

If the US stock market crashes on Friday, August 9, so much so that both the S&P 500 and the Nasdaq 100 fall 20% from their recent July all-time highs, then some kind of action may be expected over the weekend. The level for the S&P 500 is 4,533; the level for the Nasdaq 100 is 16,540. I also expect the 2-year US 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 depreciate again, the crisis will be over in short order. The unwinding will continue, albeit at a slower pace. I think the market will go haywire again between September and November as the USD/JPY pair continues to move toward 100. There will definitely be a response this time as the US presidential election is just a few weeks or days away.

Trading crypto is hard.

Two opposing forces influence my crypto positions.

Liquidity Positive Force:

After a quarter of net restrictive policy, the US Treasury will be a net injector of USD liquidity as it issues Treasury bills and potentially drains the Treasury's total account. This policy shift was spelled out in the recent quarterly refunding announcement. TL;DR: Bad girl Yellen will inject $301 billion to $1.05 trillion between now and the end of the year. I will explain this in a follow-up article if necessary.

Liquidity Negative Force:

This is the strength of the yen. The unwinding of the trade leads to a coordinated global sell-off of all financial assets as increasingly expensive yen debts must be repaid.

Which force is stronger really depends on how fast the carry trades are unwound. We cannot know this in advance. The only observable effect is the correlation between Bitcoin and USD/JPY. If Bitcoin trades in a convex fashion, meaning it rises when the USD/JPY pair strengthens or weakens significantly, then I know that the market is anticipating a bailout if the yen is too strong and liquidity provided by the US Treasury is ample. 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 is pointing to convex-Bitcoin, I will be aggressively adding to my position because we have hit a local bottom. If the market is pointing to correlated-Bitcoin, then I will be sitting on the sidelines and waiting for the final market capitulation. The biggest assumption is that the Bank of Japan does not change course and cut the deposit rate to 0% and resume unlimited JGB purchases. If the Bank of Japan sticks to the plan laid out at the last meeting, the carry trade will continue to unwind.

This is the clearest guidance I can give at this time. As always, these trading days and trading months will determine your returns in this bull cycle. If you must use leverage, use it wisely and constantly monitor your positions. When you have a leveraged position, you better hold onto your Bitcoin or shitcoins. Otherwise, you will get liquidated.

I still have the last bit of August left to enjoy.