The Federal Reserve will soon cut interest rates. That means the US dollar could weaken against the yen. This has fueled fears that the yen carry trade could be halted, triggering another global stock meltdown.
Federal Reserve Chair Jerome Powell announced last week that the US central bank is ready to cut federal interest rates.
That's certainly good news for risk-on assets like bitcoin and tech stocks. However, BitMEX co-founder Arthur Hayes Argued In a blog post on Wednesday, the move risks a repeat of Japan-led market panic.
“We are forgetting that these future expected rate cuts by the Fed, the Bank of England and the European Central Bank will narrow the interest rate differential between these currencies and the yen,” Hayes wrote.
“The risk of a yen carry trade unwinding will reappear and derail the party,” Hayes said.
Yen carry trade
Investors take advantage of Japan's low interest rates to borrow yen and buy high-yielding US equities and bonds – a strategy known as a “carry trade”.
In late July, the Bank of Japan announced that it would raise interest rates to combat inflation. The decision caused global market panic on August 5, meaning investors would have to sell their US holdings to pay interest on their borrowed yen.
On that day, Japan's Nikkei and TOPICS — the country's two largest stock market indexes — lost more than 12%, marking their worst day since the 1987 market crash.
The S&P 500 and Nasdaq fell 4.2% and 6.3%, while Bitcoin and Ethereum briefly fell 15% and 20%, respectively.
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Hayes said the BoJ was “underwhelmed” by the announcement that it would no longer raise rates, adding that markets would still be at risk if the yen strengthened against the US dollar meaningfully.
This is because investors who operate a yen carry trade face losses if they have to repay their yen loans with depreciated dollars.
The yen showed signs of strengthening against the dollar immediately after the BoJ's rate hike, so it may follow suit when US interest rates ease. In both cases, the dollar/yen interest rate differential narrows.
“If rate cuts by the three largest global economies cause the yen to strengthen against their domestic currencies, we should expect a negative market reaction,” Hayes wrote.
And that reaction would “overwhelm” any benefits gained from US rate cuts, he said, because “the world's financial assets funded in yen are in the tens of trillions of dollars.”
A risky solution
Hayes said that if the carry trade is halted as a result of low interest rates, the US central bank will respond by stimulating markets with additional liquidity.
First, the Federal Reserve will end its quantitative tightening program – through which its balance sheet has been shrunk, thus removing liquidity from the system – and second, it will begin reinvesting in US Treasuries.
If that doesn't do the trick, the US central bank will resort to quantitative easing through money printing. The Treasury, meanwhile, can draw on $740 billion left in the Treasury General Account, which serves as the department's checking account.
Hayes says all this activity will exacerbate inflation
“For an asset in limited supply like Bitcoin, it offers a trip to the moon at lightspeed!” He wrote.
Tom Carreras is a market correspondent at News. Got a tip about Bitcoin and macroeconomics? Reach [email protected]
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