Author: Moonypto Source: medium Translation: Shan Ouba, Golden Finance
The core reason for the sharp pullback of risk assets, led by US technology stocks, is that the Bank of Japan has raised interest rates sharply, causing multiple paths of yen carry trade to fail or face greater risks, which are specifically manifested in three aspects: exchange rate fluctuations, interest rate reversals, and liquidity risks.
Abenomics and Japan's long-term negative interest rate environment have made the yen an important global financing and carry trade asset
People with a little background in economics may be familiar with the so-called "lost twenty years of Japan". After the Japanese bubble economy burst in the early 1990s, the economy fell into a long period of stagnation and entered the so-called "lost twenty years". During this period, economic growth was slow and corporate and individual investment willingness was sluggish, leading to continued deflation. In response to the economic recession, the Bank of Japan began to implement a low interest rate policy in the late 1990s, lowering the benchmark interest rate to near zero to stimulate economic activity by reducing borrowing costs. As traditional monetary policy tools become less effective, it was in this context that former Japanese Prime Minister Shinzo Abe launched a series of economic policies after taking office for the second time in 2012, with the core goal of stimulating economic growth, ending long-term deflation, and solving the structural problems of the Japanese economy. The core framework of Abenomics is the "three arrows". Let me briefly introduce the bold monetary policy, which mainly includes two aspects: First, the Bank of Japan implemented a large-scale quantitative easing policy. The Bank of Japan injected a large amount of funds into the market by purchasing assets such as government bonds to lower interest rates and increase liquidity. Second, the Bank of Japan officially launched a negative interest rate policy in 2016. The policy is intended to further reduce the cost of interbank lending and encourage more funds to flow into the real economy, thereby stimulating consumption and investment and raising inflation expectations. It is worth noting that the "negative interest rate" here does not mean that the lender needs to pay interest to the borrower, but that the actual interest rate is negative, that is, the interest rate is lower than the domestic inflation rate. Against this background, a carry trade has gradually become popular, namely the yen carry trade. The market has given traders who engage in this kind of carry trade an interesting name - "Mrs. Watanabe". Yen carry trade is an investment strategy based on interest rate differentials. Its basic principle is to borrow low-interest currencies (such as the yen) and then invest the funds in high-interest currencies or high-yield assets to earn interest rate differentials. Its operating principle is as follows: 1. Borrowing yen: Since interest rates in Japan are very low (sometimes close to zero), investors can borrow yen at very low costs. 2. Exchange high-yield currencies: Exchange the borrowed yen for other currencies with higher interest rates, such as the Australian dollar or New Zealand dollar. 3. Invest in high-yield assets: Invest funds in bonds, deposits or other assets in high-yield currency countries to earn higher interest income. 4. Interest rate differential income: Investors' profits come from the difference between the borrowing cost (low-interest yen loans) and the investment income (high-interest assets).
This type of interest rate arbitrage transaction is also widely used in the DeFi field, and the typical one is LSD-ETH interest rate arbitrage. For example, on lending platforms such as Compound, ETH is borrowed with stETH as collateral, and then exchanged back to stETH. If the borrowing rate of ETH is lower than the yield of stETH throughout the process, there is room for interest rate arbitrage. The same principle applies to the yen arbitrage trading market. Generally, there are two operation paths: the first is to borrow yen with US assets as collateral and directly buy high-dividend stocks of Japan's five major trading companies, which is also one of Warren Buffett's core investment portfolios in recent years. The second path is to borrow yen and then sell it in exchange for US dollars, and buy high-interest financial instruments such as US stocks and US bonds. This is similar to the DeFi cycle lending strategy mentioned above.
This trading method has become extremely popular after the United States officially entered the interest rate hike cycle in 2022. As the Federal Reserve raises interest rates, major economies around the world have also entered an interest rate hike cycle to stabilize exchange rates and prevent capital outflows. Only Japan adheres to the low interest rate policy, making the yen the main source of low-cost financing in the tightening cycle. Of course, some people will say that the RMB interest rate is also low, but considering the international political background and China's financial sovereignty dividend, the RMB is not suitable as an arbitrage trading asset. Therefore, it can be said that the reason why the US "Seven Sisters of Technology" market can remain strong in this tightening cycle is inseparable from the support of the yen.
This is good and bad for Japan. On the positive side, due to the "Buffett arbitrage path", the Japanese stock market has been rising for a long time, forming a rare "wealth effect" in the country. We know that the vitality of the economy is mainly based on the wealth effect. When people find it easier to accumulate wealth and remain optimistic about future returns, they dare to increase investment or consumption, thereby generating economic vitality. With the help of foreign capital, Japan has seen a surge in "Japanese value", and the wealth effect brought about has turned Japan from long-term deflation to moderate inflation, basically realizing the original intention of Abenomics.
But on the other hand, another arbitrage path has led to a large amount of yen being converted into dollars to buy U.S. assets, resulting in a long-term depreciation trend of the yen against the U.S. dollar. From 2021 to 2024, the exchange rate of the U.S. dollar against the yen rose from a low of 103 to 160, and the yen depreciated by more than 60%. However, considering the impact of exchange rate fluctuations on national perception, it did not strongly affect domestic sentiment, so even with such a depreciation, Japan's inflation rate has been steadily rising.
The confrontation between the Bank of Japan's forward guidance and the speculative market has recently come to an end, and the yen has experienced a V-shaped reversal
After more than two years, the trend has recently reversed, naturally because the U.S. interest rate hike cycle is nearing its end. At the beginning of 2024, the new Bank of Japan Governor Kazuo Ueda reversed the negative interest rate policy of his predecessor Haruhiko Kuroda and began to provide the market with forward-looking guidance on interest rate hikes. But the market seemed to be skeptical and chose to confront the Bank of Japan, resulting in a depreciation of the yen above 160 in the first half of this year. One explanation is that the speculative market does not believe in the sustainability of Japan's inflation and believes that once the United States enters a rate cut cycle, Japan will return to deflation. Another explanation comes from the complex hedging needs in the yen carry trade path, of which Nvidia is the core. Simply put, Japanese electronic chip stocks, Taiwan Semiconductor and Nvidia have a strong correlation in stock prices due to the political and industrial transfer background. For a long time, buying Japanese chip stocks has been an important channel to capture alpha returns in the AI field. But entering 2024, the US stock market has shown a clear "contraction" trend, and funds have flocked to it, especially Nvidia, causing Japanese chip stocks to decouple from Nvidia. In order to avoid selling Japanese electronic stocks and losing future alpha returns, many funds have hedging needs, and selling yen and buying Nvidia has become a good choice. This view comes from Fu Peng, an economist I admire very much. If you are interested, you can go to his official account to see this logic.
Whatever the reason, the confrontation ended last Wednesday with the Bank of Japan's official 15 basis point interest rate hike, far exceeding market expectations, marking the official reversal of the market. First, we can see that the USD/JPY exchange rate has risen rapidly from 160 to 143 at the time of writing. The yen carry trade officially ended, and many traders began to close their positions, resulting in a large sell-off of risky dollar-denominated assets, which were exchanged back to yen to repay debts.
Therefore, after the weekend, as the market fully digested the news of Japan's interest rate hike, the unwinding wave reached a climax, triggering the crypto market crash on August 5. One evidence to support this is that the decline in income-yielding assets far exceeded that of zero-interest assets such as Bitcoin, especially ETH, which is the core target of interest rate arbitrage.
In the US-Japan alliance, the central bank of Japan plays a supporting role, and the US dollar ultimately determines the future trend
Here, I would like to give a brief outlook on the future trend. I hope everyone will not be scared by this pullback. Although the scale of the yen carry trade is large, I think Japan actually plays a supporting role in the US-Japan alliance. Japan's recent announcement of an interest rate hike is also just to cooperate with the US monetary policy. We know that the reason why the United States did not enter a recession early and the reason why the Federal Reserve has been slow to cut interest rates is because of the active U.S. stock market. Although small and medium-sized enterprises are struggling, the wealth effect brought by the "Seven Sisters of Technology", especially Nvidia, has kept the U.S. GDP strong through the financial sector. If the United States cuts interest rates too early, it will greatly stimulate the risk market and may reignite inflation, which is obviously unacceptable. But considering the current economic situation in the United States, there is no choice but to cut interest rates. Therefore, the Federal Reserve needs to find a reason to cut interest rates, and this reason is actually the correction of the U.S. stock market. Therefore, the actions of the Bank of Japan can be understood as part of this policy coordination.
So when the United States officially enters the interest rate cut cycle and liquidity is relaxed again, crypto assets will inevitably pick up. So everyone should still be patient and optimistic about the future. Of course, for people with high leverage, it is also an inevitable choice to reduce leverage appropriately.
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