Factors impacting markets are numerous and diverse. This article is a quick digest and speculation on the cause-and-effect relationship between the JPY/USD exchange rate and the crypto market.
JPY/USD has been in a steady downtrend since 2021, depreciating by 36% over three years. Until the Bank of Japan (BOJ) announced an interest rate hike to 0.25% on July 31, the JPY made a V-shaped turn, but this move simultaneously disrupted capital markets. The beneficiaries of Japan’s rate hike are very few, and I’ll explain my reasons later. When it comes to restoring the JPY/USD ratio, there are alternative methods to a rate hike.
Background Context
Japan is the largest foreign holder of U.S. Treasury Securities (UST) among national governments, with holdings of $1.12 trillion as of May 2024 (source). Since April 2024, Japan has been selling its UST holdings to buy yen in an effort to support its currency’s value. From the decreased amount of UST holdings, it can be deduced that Japan sold around $20 billion worth of UST in April.
Selling UST to support the yen is a reasonable strategy for Japan, but it may upset the Federal Reserve (U.S. Federal Reserve) if they continue this course of action. The consequences of selling UST are negative for the Fed:
Increase in UST yields: Rising yields mean higher costs for mortgages and loans, along with decreased confidence and demand in USTs. The most recent unemployment rate in the U.S. (4.3%) is higher than expected, fueling speculation about a potential rate cut. An increase in yields is not a welcome signal at this moment.
Weakened Dollar: The BOJ’s sale of USTs to buy yen consequently weakens the dollar. A large-scale sale can have a significant impact on the dollar’s strength.
Rate hike
In parallel with selling UST, BOJ engaged in a second attempt to support the yen through an interest rate hike. This is the second time the BOJ has raised rates; the first time increased the rate to 0.1%, and now it stands at 0.25%. The rate hike news caused a ripple effect that was destructive to the market. Why such a significant reaction? There are several layers to this story.
Signal to Constrict the Economy: The rate hike indicates a shift toward tightening monetary policy, which often leads to a decline in stock and risk asset markets. Investors tend to prefer safer bonds with higher interest rates, moving away from riskier assets like stocks and crypto.
Collapse of the Carry Trade: The carry trade is a unique Japan-related phenomenon. The BOJ has maintained its interest rates at zero or near-zero levels for over two decades, starting in the late 1990s, in an effort to combat deflation and stimulate economic growth. The low rates in Japan make borrowing yen very cheap, creating an “arbitrage” opportunity: borrowing yen to invest in higher-return assets such as U.S. Treasuries, other countries’ treasury bills, real estate, Nasdaq stocks, and crypto — essentially anything that can generate returns. This documentary shows Japanese housewives are an active group in the carry trade.
Impact on the Yen: The carry trade involves selling borrowed yen for other currencies, leading to a continuous depreciation of the yen. Like every financial operation, carry trade can involve leverage, using borrowed money to borrow more money, thereby amplifying both returns and risks. When times were good (rates were low and the yen was weak), everything was fine.
Rate hike effects: When BOJ raised rates and hinted at further increases, carry traders were screwed. A rate hike results in a stronger yen and higher borrowing costs. Carry traders now are slammed by the two brutal facts: increased costs for their borrowing and the yen appreciating, making it more expensive to pay back their debt. Their reaction is to rush to pay back the debt, which requires buying back yen, driving its value up. This explains the steep hike in the JPY/USD ratio (or a steep drop in USD/JPY, which is the other side of the coin).
Market Reactions: On Black Monday, Aug 5, capital markets fell across the board: Nikkei, Nasdaq, Crypto. Good news is Nikkei and Crypto made a V-turn recovery, bouncing back strongly the next day. However, it’s likely that volatility is not finished yet. We are still on the rocky boat.
Japanese Capital Market Booming When Yen Was Weakening
Contrary to the JPY/USD falling over the years, the Nikkei index was on a bull trend until the recent rate hike.
This situation may seem counterintuitive but it’s not hard to understand. A weaker yen makes Japanese exports cheaper and more competitive, benefiting large exporters like Toyota and Sony. Also, a weaker yen amplifies corporate revenue and earnings when foreign currency earnings translate into more yen. BOJ ‘s aggressive monetary easing directly supports stock prices. And again, the low interest rates boost confidence in stocks favoring riskier assets.
Why Is a Weaker Yen a Problem, Then? Stocks were climbing, carry traders were earning, unemployment was low (~2.4%, lower than USA and EU), and foreigners were migrating to or vacationing in Japan due to its lower costs.
The problem is everything has its threshold. When the falling yen reaches a point where the cost of imported goods, especially energy, raw materials, becomes unbearably high, it can lead to cost-driven inflation. On the financial market side, investors may become wary of yen-denominated assets, leading to capital outflows.
Also, China won’t be happy. The weak yen impacts China’s exports. It is reasonable to deduct that China will depreciate the RMB accordingly to maintain its competitive position in exports. Nation-states can regulate their currency’s circulation and value, unlike Bitcoin, which cannot be controlled by any single entity.
So what’s next?
In this section, I will discuss speculative strategies based on reasonable deductions. These are potential solutions for the BOJ to restore the yen’s value: raise rates, sell UST to buy yen, or get help. My logic for evaluating these options is based on analyzing who benefits and who gets harmed by each approach.
Option 1: Raise Rates
Who benefits: NO ONE
Logically, a rate hike benefits Japanese Government Bond (JGB) holders. But who are the biggest JGB holders? BOJ itself lol. BOJ owns more than 50% of all outstanding JGBs. With such large holdings, even a small rate hike can lead to significant valuation losses.
The loss comes from the inverse relationship between interest rates and bond prices — when rates increase, bond prices decrease. Using bond math, if BOJ were to increase rates to the same level as UST, it would make a loss of $1 trillion. This estimation is credit to Arthur Hayes’s work. Why should BOJ engage in self-harm?
The second largest holders of JGB are Japanese banks and financial institutions. They collectively hold around 20% of JGBs. These banks would also be negatively impacted by rate hikes for the same reasons as the BOJ.
The victim groups extend to the broader financial markets, S&P, Nasdaq, leverage traders, crypto degens and housewives.
Just a week from the rate hike announcement, the BOJ already said “they will not hike rates when market unstable”. I speculate that their attempted rate hike was merely “testing the waters” or a strategic move to justify what they truly intend to do.
Option 2: Selling UST to buy Yen
Who benefits: BOJ
Who gets harmed: Fed
As explained earlier, when BOJ sells UST to buy yen, it benefits by supporting yen’s value. But this action has negative repercussions for the U.S. economy: increased UST yields and weakened dollar.
In this benefit-loss equation, it is clear that the game cannot follow this route. Of course, the Fed cannot “force” BOJ to refrain from doing things they don’t like. They can offer “help”, which leads to Option 3.
Option 3: Dollar Liquidity Swap
Who benefits: BOJ, Fed
Who gets harmed: Dollar Price
A dollar liquidity swap is when the Fed swaps U.S. dollars for another currency with a foreign central bank, in this case, the BOJ. This type of swap is used to provide dollar liquidity to foreign markets during times of financial stress and to help stabilize exchange rates. This is the official site to monitor the swap lines. However, I can’t be sure if all the swap volumes show up on this site. Monitor the volume change as a reference. When the swap to BOJ is bigger, you know what is happening.
Since fiat currency is controlled by the central banks, they can hit the print bottom and swap U.S. Dollar <-> Yen. In this arrangement, BOJ gets dollars to buy yen, and Fed gets yen. The swapped dollars enter the market, pumping liquidity in circulation thus devaluing the dollar. The consequences are a mix of pros and cons for the Fed. Pros: stock market rises, dollar-nominated assets price rise, stronger exports, economy booms; Cons: dollar gets devalued. However, if the devaluation is limited in scope, it might not cause significant harm.
I estimate they’d choose option 3, a solution that seemingly benefits everyone in the short term. “Short term” is a keyword. Especially with the imminent U.S. election, the first priority of the current mandate office is artifacting a good economy and making voters happy.
How will Bitcoin perform if the liquidity swap is chosen?
The pro of injecting liquidity is that it will favor risk assets; the con is a weakened dollar. Realistically speaking, Bitcoin is still considered a risk asset at this stage; it has not yet achieved the status of gold. At the very core, inflated liquidity should favor Bitcoin’s price. However, the effect of liquidity swap will play out alongside the carry trade unwind — closing or reducing the trade position which involves selling invested assets, buying yen and repaying the debt. A weakened dollar comes with a stronger yen, meaning more expensive debt to pay.
How strong the yen will be directly impacts the scale of the unwinding carry trade. Asset selling in unwinding carry trade will pull the market down. Will Bitcoin react more to the inflated liquidity (go up) or to the selling pressure (go down)? The majority of sell-off assets won’t be Bitcoin but Tradfi assets. A proxy that may help us estimate Bitcoin’s reaction is its correlation with the Nasdaq. Using data from January 1, 2020, to August 1, 2024, the result shows a moderate correlation. I’d say this backtesting result is inconclusive.
For hardcore believers, this event will only push Bitcoin higher. In the long term it is true. Inflation and a highly leveraged financial system only serve to set off the grace of Bitcoin. But the de-leveraging process is always bloody and volatile.
So what to do? When in doubt, DCA (dollar-cost-averaging) is the answer. I’ve talked about DCA here. So far it is the most successful thing I’ve done in this cycle.