Original title: Shikata Ga Nai

Original author: Arthur Hayes

Original translation: Ismay, BlockBeats

Editor's note: Against the backdrop of global economic turmoil and financial market volatility, Hayes explores in this article the challenges faced by the Japanese banking system during the Fed's rate hike cycle and the profound impact of US fiscal and monetary policies on global markets. By analyzing in detail the foreign exchange hedging US Treasury investment strategies of Norinchukin Bank and other Japanese commercial banks, the article reveals why these banks have to sell US Treasury bonds when interest rate differentials widen and foreign exchange hedging costs rise. Hayes further discusses the role of the FIMA repo mechanism and its impact on US-Japan financial relations, and predicts the key role of this mechanism in maintaining market stability. The article finally calls on investors to seize investment opportunities in the crypto market under the current situation.

I just finished reading Red Mars, the first book in Kim Stanley Robinson's trilogy. One of the characters in the book, Japanese scientist Hiroko Ai, often says "Shigatana" when talking about situations beyond the control of the Martian colonists, which means "nothing can be done."

This phrase came to mind when I was thinking of a title for this "short" article. This article will focus on the Japanese banks that fell victim to Pax Americana's monetary policy. What did these banks do? To earn a nice yield on their yen deposits, they engaged in the dollar-yen carry trade. They borrowed from elderly Japanese savers at home, looked around Japan, and found that all the "safe" government and corporate bonds were yielding almost zero, so they concluded that lending to Pax Americana through the U.S. Treasury (UST) market was a better use of capital because these bonds would yield higher returns even when fully hedged against exchange rate risk.

But when the US had massive inflation due to cash bribes paid to the public to appease the public into accepting being locked in their homes and injected with experimental drugs to fight the "baby wave feeling", the Federal Reserve (Fed) had to act. The Fed raised interest rates at the fastest rate since the 1980s. The result was bad news for anyone holding US Treasuries. From 2021 to 2023, rising yields led to the worst bond rally since the War of 1812. Nothing could be done!

In March 2023, the first banks’ losses seeped through the underbelly of the financial system. In less than two weeks, three major banks failed, leading the Fed to provide a blanket backstop for all Treasuries on the balance sheet of any U.S. bank or U.S. branch of a foreign bank. As expected, Bitcoin surged in the months following the bailout announcement.

Since the bailout was announced on March 12, 2023, Bitcoin is up over 200%.

To solidify this roughly $4 trillion bailout (which is my estimate of the total amount of Treasuries and mortgage-backed securities held on the balance sheets of U.S. banks), the Fed announced in March of this year that using the discount window was no longer the “kiss of death.” This window should be used immediately if any financial institution needs a quick infusion of cash to fill an intractable hole in its balance sheet caused by a fall in the price of “safe” government bonds. What do we say when the banking system is inevitably bailed out by devaluing the currency and undermining the dignity of human labor? Nothing can be done!

The Fed did the right thing for U.S. financial institutions, but what about the foreigners who also bought large amounts of U.S. Treasuries during the global funding surge from 2020 to 2021? Which country's bank balance sheets are most likely to be collapsed by the Fed? Of course, the Japanese banking system.

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

Japan's Norinchukin Bank to sell $63 billion in U.S. and European bonds

"Interest rates in the United States and Europe have risen, and bond prices have fallen. This has reduced the value of the high-priced (low-yielding) foreign bonds that Norinchukin Bank had bought in the past, causing its book losses to widen."

Norinchukin Bank was the first bank to give in and announce that it had to sell bonds. Every other bank is engaging in the same trade, as I explain below. The Council on Foreign Relations gives us an idea of the size of the huge bond sales that Japan's commercial banks may have.

Japan's commercial banks held about $850 billion in foreign bonds in 2022, according to the International Monetary Fund's Coordinated Survey of Portfolio Investments. That included nearly $450 billion in U.S. bonds and about $75 billion in French bonds—a figure that far exceeded their holdings of bonds issued by the other large eurozone countries.

Why is this important? Because Yellen will not allow these bonds to be sold on the open market and cause U.S. Treasury yields to spike. She will ask the Bank of Japan (BOJ), which is supervised by the Bank of Japan, to buy these bonds. The BOJ will then 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 U.S. Treasuries and receive newly printed dollars overnight.

An increase in the FIMA repo facility indicates an increase in U.S. dollar liquidity in global currency markets. You all know what this means for Bitcoin and cryptocurrencies…which is why I thought it was important to remind readers about another invisible money printing avenue. This is how Yellen prevented these bonds from entering the open market, which I only understood after reading a dry Atlanta Fed report titled “Offshore Dollars and U.S. Policy.”

Why now

The Fed signaled at the end of 2021 that it would start raising policy rates in March 2022, and from that point on, U.S. Treasuries (USTs) began to collapse. It’s been more than two years, so why would a Japanese bank choose to recognize its losses now after two years of pain? Another strange fact is that according to the consensus view of economists, whom you should listen to: the U.S. economy is on the verge of a recession. Therefore, the Fed is likely to cut interest rates in a few meetings. Rate cuts will drive bond prices higher. Since all the "smart" economists tell you that relief is just around the corner, why sell now?

The reason is that Norinchukin Bank's FX hedged purchases of USTs went from slightly positive to sharply negative returns. Before 2023, the interest rate differential between the dollar and the yen was minimal. Then the Fed diverged from the Bank of Japan (BOJ) by raising rates, while the BOJ stuck with -0.1%. As the gap widened, the cost of hedging the dollar risk embedded in the US Treasuries outweighed the higher yields.

Here's how it works. Norinchukin Bank is a Japanese bank that holds yen deposits. If it wants to buy higher-yielding US Treasuries, it must pay in dollars. Norinchukin Bank will sell yen today and buy dollars to buy the bonds; this is done in the spot market. If Norinchukin Bank does only this, and the yen appreciates before the bond matures, Norinchukin Bank loses money when it sells the dollars back to yen. For example, you buy dollars today at USDJPY 100 and sell them tomorrow at USDJPY 99; the dollar depreciates and the yen appreciates. Therefore, Norinchukin Bank typically sells dollars and buys yen in the three-month forward market to hedge this risk. It rolls over every three months until the bond matures.

Typically, three-month forward contracts are the most liquid. That's why banks like Norinchukin use rolling three-month forward contracts to hedge ten-year currency purchases.

As the USD-JPY interest rate differential widens, forward points become negative because the Fed's policy rate is higher than the Bank of Japan's rate. For example, if spot USDJPY is 100 and the US dollar yields 1% more than the yen over the next year, the USDJPY one-year forward price should be around 99. This is because if I borrow 10,000 yen today at 0% interest to buy 100 US dollars, and then deposit the 100 US dollars to earn 1% interest, I will have 101 US dollars in a year. What should the USDJPY one-year forward price be to offset this $1 interest income? About 99 USDJPY, which is the no-arbitrage principle. Now imagine I did all this just to buy a US Treasury bond that yields only 0.5% more than a similar maturity Japanese Government Bond (JGB). I am effectively paying a negative yield of 0.5% on this trade. If this were the case, Norinchukin or any other bank would not have made this trade.

Back to the chart, as the differential widens, the three-month forward point becomes so negative that the yield on a US Treasury bond FX-hedged back to JPY is lower than buying the JPY-denominated JGB outright. Starting in mid-2022, you will see the red line representing USD is below 0% on the X-axis. Remember, the Japanese bank buying the JPY-denominated JGB has no currency risk, so there is no reason to pay the hedging fee. The only reason to make this trade is when the yield after FX hedging is >0%.

Norinchukin Bank is in a worse situation than the long-term lover of FTX/Alameda. From a market value perspective, the US Treasuries that might have been purchased in 2020-2021 are down 20% to 30%. In addition, the cost of FX hedging has increased from negligible to over 5%. Even if Norinchukin believes the Fed will cut 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 Treasuries.

Any plan that would allow Norinchukin to pledge US Treasuries in exchange for new dollars would not solve the cash flow problem. The only thing that would return Norinchukin to profitability from a cash flow perspective would be a significant narrowing of the policy rate gap between the Fed and the Bank of Japan. Therefore, the use of any Fed program, such as the Standing Repo Facility, which allows US branches of foreign banks to buy back US Treasuries and mortgage-backed securities in exchange for newly printed dollars, is ineffective in this case.

As I wrote this, I racked my brain to think of any other financial means that Norinchukin could have avoided selling bonds. But as mentioned above, the existing plans are all some form of loans and swaps. As long as Norinco holds the bonds in any form, the currency risk remains and must be hedged. Only after the bonds are sold can Norinco unwind its FX hedge, which is a huge cost for it. That is why I believe Norinco's management has explored all other options and selling the bonds is a last resort.

I will explain why Yellen is unhappy about this situation, but for now, let's close Chat GPT and use our imaginations. Is there a Japanese public institution that can buy bonds from these banks and take on the USD interest rate risk without fear of bankruptcy?

Ding Dong

Who's there?

It's the Bank of Japan.

Bailout Mechanism

The Bank of Japan (BOJ) is one of the few central banks that can use the FIMA repo facility. It can hide the price discovery of US Treasuries in the following way:

The BOJ "gently suggested" that any Japanese commercial bank that needs to sell US Treasuries, sell these bonds directly onto the BOJ's balance sheet, rather than selling them on the open market, and settle at the current last traded price without affecting the market. Imagine you could dump all of the FTT tokens at market price because Caroline Allison is there to back the market and can provide support at any scale necessary. Obviously, this doesn’t work well for FTX, but she’s not a central bank with a printing press. Her printing press can only handle $10 billion of customer funds, while the Bank of Japan handles unlimited.

Then the Bank of Japan uses the FIMA repo facility to swap US Treasuries for dollars that the Fed has printed out of thin air.

One, two, lace up your shoes. That’s an easy way to circumvent the free market. Man, that’s 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 losses on the bonds due to rising interest rates are still there. Who is the sucker?

The Bank of Japan will still recognize a loss for selling the bonds to the Bank of Japan at the current market price. The BoJ now takes on future U.S. Treasury maturity risk. If the price of these bonds falls, the BoJ will have unrealized losses. However, this is the same risk the BoJ currently takes on its multi-trillion yen JGB portfolio. The BoJ is a quasi-governmental entity that cannot go bankrupt and does not need to comply with capital adequacy requirements. It also does not have a risk management department that forces position reductions when its Value-at-Risk rises due to huge DV01 risk.

As long as the FIMA repo mechanism exists, the BoJ can roll over its repo daily and hold U.S. Treasuries until maturity.

How is the supply of dollars increased?

A repo requires the Fed to provide dollars to the Bank of Japan in exchange for U.S. Treasuries. This loan is rolled over daily. The Fed gets these dollars through its printing press.

We can monitor the dollars injected into the system on a weekly basis. The name of the program is "Repo Agreements - Foreign Official".

As you can see, FIMA repo is very small right now. But the sell-off has not started yet, and I imagine there will be some interesting phone exchanges between Yellen and BoJ Governor Ueda. If I'm not mistaken, this number will increase.

Why Help Others

Americans are not known for their sympathy for foreigners, especially those who don't speak English and have strange looks. Appearance issues are relative, but to those tanned, Confederate flag-waving rednecks living in the flyover states, the Japanese just don't look right. And you know what? These vulgar people will decide who the next emperor will be this November. It's speechless.

The reason Yellen would lend a helping hand despite the underlying xenophobia is that without new dollars to absorb these junk bonds, all the big Japanese banks would follow Norinchukin Bank's lead and sell off their US Treasury portfolios to ease the pain. This would mean $450 billion worth of US Treasuries would quickly hit the market. This cannot be allowed because yields would soar, making financing the federal government very expensive.

Here’s why the FIMA repo facility was created, as the Fed’s own words put it:

“During the ‘cash rush’ of March 2020, central banks simultaneously sold U.S. Treasuries and parked the proceeds in overnight repos at the New York Fed. In response, the Fed offered in late March to agree to provide central banks with overnight loans using U.S. Treasuries held in custody at the New York Fed as collateral, at an interest rate above private repo rates. This loan would allow central banks to raise cash without forcing outright sales in an already strained Treasury market.”

Remember September-October 2023? During those two months, the Treasury yield curve steepened, causing the S&P 500 to fall 20% and the yields on 10-year and 30-year Treasury bonds to exceed 5%. In response, Yellen shifted most of her debt issuance to short-term Treasuries to drain the cash from the Fed’s reverse repo program. This boosted the market, and starting on November 1st, all risk assets, including cryptocurrencies, began to rise.

I am very confident that in an election year, when her boss is threatened with defeat at the criminal hands of the Orange Man, Yellen will fulfill her responsibility to "democracy" and ensure that yields remain 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 Treasuries on the open market, but to use the FIMA repo mechanism to absorb the supply.

Trading Strategy

Everyone is watching closely to see when the Fed will finally start cutting rates. However, the USD-JPY interest rate differential is +5.5% or 550bps, which is equivalent to 22 rate cuts (assuming the Fed cuts by 0.25% per meeting). One, two, three, or four rate cuts over the next twelve months will not significantly reduce this differential. Moreover, the BoJ has shown no willingness to raise its policy rate. At most, the BoJ may reduce the pace of its open market bond purchases. And the reasons why Japanese commercial banks must sell off their FX-hedged US Treasury portfolios are not addressed.

That is why I am confident that the move from Ethena-collateralized USD (sUSDe), currently earning 20-30% yields, to crypto risk assets will accelerate. Given this news, the pain has reached a point where Japanese banks have no choice but to exit the US Treasury market. As I stated, the last thing the ruling Democratic Party needs in an election year is a big rise in Treasury yields, as this would impact the main financial concerns of the median voter, namely mortgage rates, credit card and auto loan rates. If Treasury yields rise, these rates will all rise.

This is exactly why the FIMA repo facility was created. All that was needed now was for Yellen to firmly ask the Bank of Japan to use it.

Just when many began to wonder where the next shock to USD liquidity would come from, the Japanese banking system delivered brand new USD composed of origami cranes to crypto investors. This is just another pillar of the crypto bull market. In order to maintain the current USD-based Pax Americana filthy financial system, the USD supply must increase.

Say it with me, “Shikata ga nai”, and buy the dips!

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