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Arthur Hayes: The monetary policy game between China, the United States and Japan will help the crypto bull market return

BlockBeats2024/05/21 02:18
By:BlockBeats
Original title: The Easy Button
Original author: Arthur Hayes, BitMEX co-founder
Original translation: TechFlow



Introduction: Arthur deeply analyzes how the global elite use policy tools to maintain the status quo, even though these tools will bring pain now or in the future. The core point he made is that the exchange rate between the US dollar and the yen is one of the most important global economic variables, and explores the complex monetary policy interactions between Japan, the United States and China and their profound impact on the global economy.


The global elites have a variety of policy tools to maintain the status quo, which will bring pain now or in the future. I am skeptical and believe that the only goal of elected and unelected bureaucrats is to maintain power. Therefore, the easy button is always pressed first. Hard choices and strong measures are best left to the next government.


It would take a very long series of posts to fully explain why the USD/JPY exchange rate is the most important global economic variable. This is my third attempt to describe the chain of events that led us to crypto heaven. Rather than providing a complete and comprehensive picture, I will start by giving readers the easy button, as they do. If policymakers abandon the use of this tool, then I know that longer, more difficult, and more drawn-out corrective actions will be taken. At that point, I can provide you with a more complete explanation of the sequence of monetary events and the relevant historical perspective.


The real “oh, they are really screwed” moment came when I read two recent Solid Ground newsletters written by Russell Napier. These newsletters describe the dilemma faced by the monetary elites who preside over peacetime in Japan and the United States. The most recent newsletter, published on May 12, describes the easy buttons available to the Bank of Japan (BOJ), the Federal Reserve (Fed), and the U.S. Treasury.


Very simply, the Fed, under the direction of the Treasury Department, can legally exchange unlimited amounts of dollars and yen with the Bank of Japan, at any time and at any place. The Bank of Japan and the Ministry of Finance of Japan (MOF) can use these dollars to manipulate the exchange rate by buying yen. By strengthening the yen in this way, the following situations are avoided:


1. The Bank of Japan raises interest rates, in the process forcing regulated pools of money such as banks, insurance companies and pension funds to buy Japanese government bonds (JGBs) at high prices and low yields.


2. In order to buy these high-priced JGBs, these pools have to sell their US Treasuries (UST) to raise dollars to buy yen and repatriate them.


3. The Japanese Ministry of Finance sells US Treasuries to raise dollars to buy yen.


If Japanese companies - the largest holders of US Treasuries - do not become forced sellers, this helps the US Treasury continue to finance the profligate federal government at negative real interest rates. Otherwise, the Treasury will have to initiate yield curve control (YCC). This is the ultimate destination, but it must be postponed as long as possible because of the obvious inflation and possible hyperinflationary effects.


Seppuku


Who is the largest holder of JGBs? The Bank of Japan.


Who is in charge of Japan's monetary policy? The Bank of Japan.


What happens to bonds when interest rates rise? Prices fall.


Who loses the most if interest rates rise? Bank of Japan.


If the Bank of Japan raises interest rates, it will commit seppuku. Given its strong instinct for self-preservation, the institution will not raise interest rates unless there is a solution to spread the losses to other financial players.


If the Bank of Japan does not raise interest rates and the Fed does not cut rates, the USD/JPY differential will remain. Investors will continue to sell the yen because the dollar yields more than the yen.


China is not happy



China and Japan are direct export competitors. In many industries, the quality of Chinese goods is comparable to that of Japanese goods. Therefore, the only thing that matters is the price. If the RMB/JPY exchange rate rises (weaker yen against stronger RMB), China's export competitiveness will suffer.



China will not like this RMB/JPY exchange rate chart.


China wants to escape deflation by making and exporting more goods.



Real Estate = Bad


Manufacturing = Good


That's where the cheap bank credit will flow.



As you can see, China and Japan are neck and neck in the emerging passenger car export market. I use this as an example of global export competition. This is the most important export market given the number of cars purchased each year. In addition, the Global South countries are young and growing, and their number of cars per capita will increase in the coming years.


If the yen continues to depreciate, China will respond by devaluing the yuan.



The People's Bank of China (PBOC) has essentially pegged the yuan to the dollar since 1994, with a slight strengthening bias. That's what this USDCNY chart shows. That's about to change.


China has to devalue the yuan implicitly by creating more RMB credit onshore, and explicitly through a higher USDCNY value, so that exports beat Japan in price. China has to do this to fight the deflationary collapse that will come from the bursting of the real estate bubble.



The GDP deflator converts nominal GDP into real GDP. A negative number means prices are falling, which is not a good thing for a debt-based economy. Because banks extend credit with collateralized assets, when asset prices fall, debt repayment becomes a problem and its price falls as well. This is deadly, and is why China and every other global economy needs inflation to function.


Creating the needed inflation is easy; just print more money. However, China’s money printing press is not fully operational. Credit, as always, is created by the commercial banking system.



These BCA Research charts clearly show negative credit pulses, which indicates insufficient credit money creation.



Local and central government spending is also insufficient to end deflation.



Real interest rates are positive. Growth in the quantity of money is falling, but its price is rising. Very bad.


China must create more credit, either through government spending or lending to businesses. So far, China has refrained from launching major stimulus packages like they did in 2009 and 2015. I believe this is because there are well-founded concerns that these domestic money creation policies will have a negative impact on the exchange rate, and at least for now, they want to keep it stable against the dollar.



To create the above chart, I divided China's M2 (RMB money supply) by reported foreign exchange reserves. At its peak in 2008, the RMB was 30% backed by foreign exchange reserves, mostly made up of US Treasuries and other USD assets. Currently, the RMB is only 8% backed by foreign exchange reserves, the lowest level since data became available.


If China ramps up credit creation, the money supply will increase further. This adds to the pressure for a dirty float of the RMB against the dollar. I think China wants to keep the RMB stable against the dollar for both domestic and foreign political reasons.


Domestically, China does not want to exacerbate capital flight by massively devaluing the RMB. In addition, this increases the cost of imports. China imports food and energy. When these costs rise too fast, social unrest is not far away. The lesson that any Marxist, especially a Chinese Marxist, draws from revolutionary history is that food and energy inflation rates must never be allowed to get out of control.


The key factor that China is concerned about is the peacetime American response to a devaluation of the RMB. I will discuss this in more detail later, but a devaluation of the RMB makes Chinese goods cheaper, reducing the incentive for American factories to relocate. Why would they build expensive factories and hire expensive skilled workers (if they can find them) when their final product still cannot compete on price with Chinese goods? Unless the US government provides corporate welfare on a large scale, American manufacturing companies will continue to make their products abroad.


Rust Belt



Biden is hit in states that have lost their manufacturing base over the past 30 years. If China devalues its currency, jobs will continue to be lost. If Biden doesn’t win these states, he will lose the election. Trump’s victory in 2016 came marginally from winning in these China-antipathetic Rust Belt states.


Some readers might think Biden’s aides have finally figured it out; anti-China rhetoric and actions are coming more frequently from the Biden administration. In fact, Biden just announced another increase in tariffs on Chinese-origin goods, like electric vehicles.


My counterargument is that Chinese goods don’t always come directly from China. If the product is cheap enough, China will export it to a US-friendly country first before it ends up in the US. Then, the goods are seen as coming from another country, not China.



Here is a chart of Chinese exports to Mexico (white), Vietnam (yellow), and the United States (green). Trump’s term began in 2017, which is the starting date for the index, with a value of 100. China’s trade with Mexico grew by 154%, with Vietnam by 203%, but with the United States by only 8%. Obviously, the value of trade with the United States is much higher than that of Mexico and Vietnam, but it is clear that China is using these two countries as transit points for goods to pass through their borders into the United States.


If the goods are high quality and low priced, it will enter the United States. While politicians will make a big fuss about imposing punitive tariffs on “dumped” goods, China can easily shift the destination of its exports. Countries like Vietnam and Mexico are happy to earn a small commission by allowing goods to pass through their borders into the United States.


Biden must win these battleground states to stop Trump. Biden cannot afford a devaluation of the RMB before the election. China will use this fear of losing the election to its own ends.


China Threat


Secretary of State Blinken and Treasury Secretary Yellen have visited Beijing several times over the past few quarters. I imagine the real core of the conversation revolves around the China threat.


If the United States does not let Japan strengthen the yen, China will respond by devaluing the RMB against the dollar and exporting its deflation to the world. Deflation is exported through mass-produced cheap goods.


China is also pressuring Yellen to pursue a weak dollar policy, increasing the global supply of dollars by any means necessary. This allows China to once again do a heavy stimulus because the pace of RMB credit creation will match that of the dollar on a relative basis.


In return, China will keep the dollar-RMB exchange rate stable. The RMB will not depreciate against the dollar. Perhaps China would even agree to limit the amount of products it exports to the United States to help American companies reshore production.


If Yellen and Blinken balk at this threat, I would raise the nuclear currency option.


China is estimated to have hoarded over 31,000 tons of gold. This is government and private holdings combined. The Party actually owns everything in China, so I added government and private holdings together. At today's prices, this gold is worth about $2.34 trillion. The RMB is implicitly backed by 6% gold. I divide China's reported RMB money supply by the value of all China's gold.


As mentioned earlier, China's FX reserves/M2 ratio is 8%. The RMB is backed in roughly equal proportions by dollars and gold.


My threat would be to announce a floating of the RMB against gold. China could achieve this outcome by:


1. Swap US Treasuries for gold as quickly as possible. At some point, the US may freeze Chinese assets or restrict China's ability to sell its approximately $1 trillion in US Treasuries. But I believe China can quickly sell a few hundred billion dollars of US Treasuries at fire sale prices before US politicians react.


2. Instruct any state-owned enterprises that hold US stocks or US Treasuries to also sell and buy gold.


3. Announce that the RMB will be pegged to gold at a devaluation of 20% to 30% from current levels. The price of gold in RMB will rise (XAUCNY rises).


4. Gold is trading at a premium on the Shanghai Futures Exchange (SFE) to the London Bullion Market Association (LBMA) fixing. This leads traders to arbitrage by taking delivery of gold in London through long futures contracts and taking delivery in Shanghai through short futures contracts. This moves gold from the West to the East.


5. As global gold prices rise, while physical gold stocks in LBMA member warehouses decrease, one or more major Western financial institutions go bankrupt due to lack of physical gold. It is rumored that Western financial institutions are naked shorting gold in the paper derivatives market. This would be an upgraded version of "GameStop" as it could cause the entire Western financial system to collapse due to the crazy leverage embedded in the system.


6. The Federal Reserve is forced to print money to save the banking system, increasing the supply of US dollars. This helps strengthen the exchange rate of the RMB against the US dollar.


After reading these hypothetical scenarios, readers may wonder why I think the United States can influence Japan's monetary policy. The key assumption is that by threatening the United States, China can convince the United States to instruct Japan to strengthen the yen.


In the 1970s and 1980s, Japan often agreed to strengthen the yen to reduce its export competitiveness relative to the United States and Western Europe (mainly Germany).



The above chart is the USD/JPY chart. In the early 1970s, USD/JPY was 350, imagine how cheap Japanese yen commodities were to Americans in inflation at that time.


Yellen is perfectly capable of politely suggesting that Japanese companies strengthen the yen this time to prevent Chinese retaliation.


What will Japan do if they cooperate? Let me show why Japan cannot strengthen the yen by instructing the Bank of Japan to raise interest rates and end its quantitative easing.


Japanese Debt Math


I want to quickly explain why if the Bank of Japan raises interest rates, they will melt faster than Sam Bankman-Fried on the witness stand.


The Bank of Japan owns over 50% of all outstanding Japanese government bonds. They essentially fix the price of bonds with a maturity of 10 years or less. What they really care about is the 10-year JGB rate, as that is the reference rate for many fixed income products (corporate loans, mortgages, etc.). Assume their entire portfolio consists of 10-year JGBs.


Currently, the latest 10-year JGB #374 is priced at 98.682, yielding 0.954%. Assume the BoJ raises its policy rate to match the current 10-year US Treasury yield of 4.48%. The JGB price at this point is 70.951, or a 28% drop (I used Bloomberg's bond pricing feature). Assuming the BoJ has 585.2 trillion yen in bonds, and the USD/JPY exchange rate is 156, that's a $1.05 trillion market value loss.


Losing that much money would be fatal to the BOJ’s fraud on yen holders. The BOJ holds only $32.25 billion in equity capital. Even extreme traders in cryptocurrencies don’t trade as highly leveraged as the BOJ. Seeing these losses, what would you do if you held yen or yen-denominated assets? Sell or hedge. In any case, USD/JPY would quickly rise to over 200, faster than Su Zhu and Kyle Davis could escape from a BVI court-appointed liquidator.


If the BOJ really had to raise rates to narrow the USD/JPY spread, they would first force domestic regulated pools of money (banks, insurance companies, and pension funds) to buy JGBs. To do this, these entities would sell their foreign dollar assets, primarily US Treasuries and US stocks, use those dollars to buy yen, and then buy the BOJ’s negative real yielding high-priced JGBs.


From an accounting perspective, as long as these institutions hold to maturity, they will not mark-to-market their JGB portfolios and report huge losses. However, their clients, the people whose money they manage, will be financially repressed to save the BoJ.


This is a terrible outcome from an American peacetime perspective, as the Japanese private sector will be selling trillions of dollars in U.S. Treasuries and U.S. stocks.


Whatever solution Yellen suggests to strengthen the yen, it cannot require the BoJ to raise interest rates.


Easy Button


As mentioned above, there is a way to weaken the dollar, allow China to re-stimulate its economy, and strengthen the yen without having to sell U.S. Treasuries. I will discuss how this can be solved with unlimited dollar-yen currency swaps.


In order to weaken the dollar, its supply must be increased. Imagine that Japan needs $1 trillion in firepower to strengthen the yen from 156 to 100 overnight. The Fed swaps $1 trillion for an equal amount of yen. The Fed prints dollars and the BoJ prints yen. This costs nothing to each central bank, as they each have their own domestic money printing presses.


These dollars exit the BoJ's balance sheet because the Japanese Ministry of Finance must buy yen on the open market. The Fed has no use for the yen, so it stays on the Fed's balance sheet. When a currency is created but stays on a central bank's balance sheet, it has been sterilized. The Fed sterilized the yen, but the BoJ released $1 trillion into global money markets. As a result, the dollar depreciated against all other currencies because its supply increased.


As the dollar depreciates, China can create more onshore RMB credit to combat the nasty effects of deflation. If China wants to keep the USD/CNY exchange rate at 7.22, it can create an additional RMB 7.22 trillion ($1 trillion * 7.22 USD/CNY) of domestic credit.


The RMB falls against the yen, which is a depreciation for China and an appreciation from Japan's perspective. The global supply of RMB increases, while the yen decreases because the Japanese Ministry of Finance uses dollars to buy yen. Now the yen is fairly priced against the RMB on a purchasing power parity basis.


Any asset denominated in dollars goes up in price. This is good for US stocks and the US government because it imposes capital gains taxes on profits. This is good for Japanese companies because they collectively have over $3 trillion in USD assets. Cryptocurrencies soar because there is more USD and RMB liquidity in the system.


Domestic inflation in Japan falls because the cost of imported energy falls due to the stronger yen. However, exports will suffer due to the stronger currency.


Everyone gains, some more than others, but it helps keep the global dollar system intact ahead of the U.S. presidential election. No country needs to make a painful choice that negatively affects its domestic political standing.


To understand the risk to the U.S. of engaging in such behavior, first, I need to draw an equation between yield curve control (YCC) and this dollar-yen swap scam.


Same but Different


What is YCC?


This happens when a central bank is willing to print unlimited amounts of money to buy bonds in order to fix prices and yields at politically appropriate levels. As a result of YCC, the money supply increases, causing the currency to depreciate.


What is a dollar-yen swap arrangement?


The Fed is ready to print unlimited amounts of dollars so that the Bank of Japan can delay raising interest rates and thus avoid selling U.S. Treasuries.


The outcome of both policies is the same; namely, lower Treasury yields than they would otherwise be. In addition, the dollar will weaken as supply increases.


The swap line is politically better because it occurs in the dark. Most commoners and even nobles do not understand how these instruments work or where they sit on the Fed’s balance sheet. It also does not require consultation with the U.S. Congress because the Fed acquired those powers decades ago.


YCC is more visible and is sure to provoke a fierce backlash from concerned and angry citizens.


Risks


The risk is that the dollar depreciates too much. Once the market equates the USDJPY swap line with YCC, then the dollar will plummet to the bottom of the ocean. When the swap is unwound, it will mean the end of the dollar reserve system.


Given that it will take many years for the market to force such an unwinding, watch for politicians who support today to support expanding the USDJPY swap line.


Watch


How do you monitor if I am right or wrong?


Watch the USDJPY rate more closely than the Solana developers monitor uptime. In fact, watch more closely…


The USDJPY spread problem has not been resolved. Therefore, the yen will continue to weaken regardless of intervention. After each intervention, open this page and monitor the size of the USDJPY swap line. On Bloomberg, monitor the FESLTOTL index. If it starts to increase significantly, and I mean in billions of dollars, then you know this is the path the elites have chosen.


At this point, add the size of the dollar swap line to your dollar liquidity index. Sit back and watch the rise in fiat-denominated cryptocurrencies.


WRONG


I could be wrong in two ways.


The Bank of Japan changes its weak yen policy by raising rates significantly and says it will continue. By significantly raising, I mean 2% or more. A mere 0.25% rate hike will not cut the 5.4% interest rate differential between the dollar and the yen.


The yen continues to weaken, and the US and Japan do nothing about it. China retaliates by either devaluing the yuan against the dollar or pegging it to gold.


If any of the above happens, it will eventually lead to some form of YCC for the US, but the path to YCC is complicated. I have a theory about the sequence of events from here to there, and if necessary I will publish a series of articles about the journey.


Timing is key


The market knows the yen is too weak. I believe the pace of yen depreciation will accelerate in the fall. This will put pressure on the US, Japan, and China to act. The US election is a key driver for the Biden administration to come up with a solution.


I think a surge to 200 USD/JPY is enough to get the Chemical Brothers playing "Push the Button".


This is a simplified version of what all crypto traders must always monitor in USD/JPY. I believe the clown brigade running peacetime America will choose the easy way out. It is simply the politically sound choice.


If my theory comes to fruition, any institutional investor can easily buy a US listed Bitcoin ETF. Bitcoin is the best performing asset in the face of global fiat debasement and they know it. When dealing with the problem of a weak yen, I will do the math to estimate how the inflows into the Bitcoin complex can push the price to $1 million and beyond. Keep your imagination, stay optimistic, this is not the time to be a wimp.


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