The Bank of Japan Triggers Global Liquidations After Its 0.15% Rate Hike

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the cliff-notes:

• The yen carry trade has become unprofitable due to recent rate hikes by the Bank of Japan.
• Investors are liquidating assets bought with borrowed yen, causing significant market turmoil.
• Key financial indices and assets, including the Nikkei 225, S&P 500, and Bitcoin, have experienced sharp declines.

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What happened on Sunday night, and what's going on today?

Well, it all has to do with the sudden unprofitability of the yen carry trade. For more than 25 years, the Japanese Yen has been one of the world's foremost borrowing currencies. The Bank of Japan has kept its policy interest rates low and eventually negative in nominal terms for the past several decades in an effort to fight deflation and spur growth by encouraging spending.

The byproduct of this has been global borrowers tapping into Japan's comparatively low-rate money markets to borrow, then investing in other countries' financial markets where higher yields can be found to capture the difference. This is what's called a carry trade, a mechanism where investors borrow in a currency with low interest rates to invest in higher-yielding assets elsewhere.

The viability of the yen carry trade relies on the differential between the borrowing currency's interest rate and investable yields remaining wide enough to be profitable. With the BOJ's two rate hikes, one in March from -0.1% to 0.1%, and one last week from 0.1% to 0.25%, the yen carry trade's profitability has been dramatically reduced. So much so that it kicked off the liquidation of the assets purchased using borrowed yen in order to pay back their JPY-denominated loans:

The impact in FX markets has been swift and severe, with the Japanese yen strengthening 10.7% against the dollar in less than 3 weeks; its sharpest strengthening move in decades. As investors dump their borrowed assets in order to cover their now-expensive rolling JPY-denominated loans and buy back the yen, this is the net effect:

An estimated $20 trillion of capital is estimated to be tied up in yen carry trades, spread across all of the world's largest financial asset markets.

This mad dash for liquidity first came for the Nikkei 225, Japan's largest stock index, which had its biggest 2-day drop in history on a non-inflation-adjusted basis. Even worse than Black Monday in 1987:

The United States was not spared from the ripple effects of what Japan did, as the yen carry trade is a wildly popular funding mechanism for US financial assets. Take a look at the carnage. Here are some highlights:

• High-yield credit spreads (for riskier corporate borrowers) have widened by 10.5% since this morning.
• Investment-grade credit spreads (for less risky corporate borrowers) have widened by 7.1% since this morning.
• VIX, the S&P 500's volatility index, spiked +42 points from market open, now down to 38.87 for a still-substantial +15 point move.
• Bitcoin fell to a low of $49,212 this morning, or a -15% drop in 24 hours. It has since recovered to $54,000, or only an ~8% drop in 24 hours.
• The S&P 500 is down 2.5% today, now down 6.7% this month.
• The Nasdaq is down 2.5% today, now down 12.2% this month.

The partial mid-day recovery in VIX, bitcoin, and most of the US stock market tells me that most of the initial move was reactionary. The sheer panic of watching Japanese markets get ravaged likely drove traders to voluntarily liquidate. A lot of today's action was driven by triggered forced liquidations which cascaded into more forced liquidations, but a fair amount of this initial one-day move was reactionary. Not even the very encouraging PMI data released at 10:00 AM was able to turn the session around. In the coming days, I'll be watching whether the rout deepens or if we see a swift bounce. If the fear deepens rather than dissipates this week and into next week, that's not an encouraging sign:

Final thought: finally, tradfi got a taste of watching your assets bleed over the weekend.

Take it easy,

Joe Consorti

Theya is the world's simplest Bitcoin self-custody solution. With our modular multi-sig vaults, you decide how to hold your keys.

Whether you want all your keys offline, shared custody with trusted contacts, or robust mobile vaults across multiple iPhones, it's Your Keys, Your Bitcoin.

Download Theya on the App Store.