The Breakdown - Does the Bank of Japan’s Intervention Spell Trouble for the US Treasury Market?

Episode Date: October 25, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   “The Breakdown” kicks off the week with a look at one of the big global macro stories shaping markets right now, which is the first Bank of Japan interventions into the country’s currency markets in two decades. Some are speculating the BoJ’s actions could have implications for the U.S. as well because Japan has to liquidate its U.S. Treasury holdings to prop up the price of the yen.  - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “War” by Enoch Yang and “The Life We Had” by Moments. Image credit: Javier Ghersi/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

this tightrope act that the Fed is walking where it wants to give itself more options, going into the fall in the winter, but not so much that the desperate hungry markets overinterpret the signal and force their hand back the other direction. And while it's tempting at this point to groan and massage one's temples at the stupidity of a system that reads tea leaves in Wall Street Journal articles, like their prognostications from the oracles of old, it is the system we have right now. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world.

The breakdown is sponsored by nexo.io, Circle, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Monday, October 24th, and today we are doing a Monday macro day. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show, I also work with FTX. All right, guys, happy Monday. And before we get into today's show, I want to give you just a little bit of a heads up about what to expect over the coming weeks. This week in particular is going to be a little bit

hectic, although hopefully it won't seem like that to you. On Thursday, the fam is traveling internationally, where we'll be for two weeks. And so over the next couple of the weeks, you'll have some regular shows, but they'll be interspersed with interviews as well. I always love having a chance to catch up with smart people that I haven't been able to talk to for a while, and we've got shows coming on privacy, on wealth managers, and their take on crypto, on NFTs in a bare market, and all sorts of other good stuff. So be on the lookout for those interviews starting later this week. Today, like I said, we are starting on the macro side of things. And of course, at this point, everywhere, people are looking for signs that financial markets are breaking in a way that might

force the Fed and the rest of the central banks of the world to pivot back to more accommodative monetary policy. For the last few days, the big part of the discussion has been on Japan. For the second time in about the last month, the Bank of Japan has stepped in to support the yen. On September 22nd, the BOJ spent around $20 billion in foreign exchange reserves to defend the yen when the exchange rate reached $145 yen per dollar. This was the first currency intervention from the Bank of Japan since 1998. The intervention pushed the exchange rate down to 140, but the reprieve was short-lived. Over the next two weeks, the exchange rate rebounded completely. On Thursday, the yen crossed the 150 yen per dollar level for the first time since 1990.

This level has been widely viewed as a line in the sand for further BOJ intervention by commenters and traders. Friday night in Japan saw a violent swing, with the exchange rate first reaching 151 before the yen spiked to 146 on the back of suspected BOJ intervention. The Monday session opened with another rapid rally for the yen, this time reaching 145 momentarily before returning to 148. Analysts estimate that if Friday's intervention was in fact an intervention, it would have cost the Bank of Japan an additional $30 billion in reserves. Now, why there's a big caveat or question mark around that is that the Bank of Japan and the Japanese government do not officially comment on currency interventions. On Saturday, the Prime Minister refused to discuss Friday's price action, simply telling reporters, quote, we are maintaining our stance of being ready to take appropriate action against excessive

Forex volatility. We remain on high alert towards the foreign exchange market and will take appropriate actions against excessive moves. We will not tolerate volatile moves due to speculative trading. Still, the consensus in the markets was that they had, in fact, intervened. Ray Atrell, who's the head of foreign exchange strategy at the National Australia Bank in Sydney, said it's blindingly obvious that the BOJ is intervening. Dollar yen wouldn't be moving like this otherwise. The question, of course, on everyone's mind is how sustainable this defense of the yen will be. In a note last week, Goldman Sachs analyst said, while suboptimal and unsustainable in the medium term,

we think this policy mix could be in place for some time. The chief foreign exchange strategist at Mitsubishi noted the currency interventions almost always fail. Quote, in the past crises involving the British pound and Italy's lira, authorities have ended up failing to defend their currencies. Likewise, Japan's stealth intervention only has limited effects. Strengthen the dollar is the biggest factor behind the weak yen. If the United States shows signs of its rate hikes peaking out and even cutting interest rates, the yen would stop weakening even without intervention. End quote. One of the differences which might make Japan's combination of ultra-easy monetary policy and periodic currency intervention more sustainable,

is there comparatively low levels of inflation. Japan currently has 3% inflation, which is higher than the BOJ's 2% target, but relatively contained compared to other developed market economies. Despite rising inflation, the BOJ has maintained their policy of pegging rates at 0.25% all the way out to the 10-year duration. The real constraint on this policy might end up being foreign exchange reserves themselves. September's $20 billion intervention cost the BOJ 15% of its liquid foreign exchange reserves, but Japan does have a gigantic $1.1 trillion war trust of foreign reserves still remaining which could be mobilized if necessary. The reserves are mostly held in U.S. sovereign debts, so this could add additional stress to an already thin treasury market.

And this is certainly on the minds of many investors. Speaking of which, turning to Twitter for a moment, there is a ton of skepticism about the long-term efficacy of these policies. Lee Drogan, the CIO of Star-Killer Capital said, when was the last time a currency intervention actually worked for more than a week or two. Stanfield Capital wrote, why does the BOJ think this currency intervention will work as long as it continues to peg 10-year bonds at 0.25% despite 3% inflation? This ain't exactly rocket science.

Dumeberg said on September 22nd, 2022, the BOJ intervened to support the yen for the first time in 24 years. It had to do it again 30 days later. How long before the next one? Duneberg also wrote, this is like watching Tether defend the peg, except Tether did it. Southern Macro added, have never seen such a consensus view that the BOJ at all will fail with their currency intervention. Now, as I mentioned before, there is a lot of discussion about how this might impact U.S. Treasuries. Lisa Abramowitz, a host at Bloomberg,

said Japanese authorities are likely to have spent more than $30 billion last week in their second intervention in a month to prop up the yen, according to estimates by traders. Gold Telegraph put that in context, saying Japan likely spent more than $30 billion last week to prop up the yen. Japan is signaled they have limitless funds to defend the country's currency. Are you still wondering why Janet Yellen is worried about treasury liquidity? In other words, what happens if Japan has to sell some meaningful portion of its treasuries into a market that doesn't want them just to keep fighting this currency battle? Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new spot and futures trading platform uses aggregated

liquidity of over 3,000 order books collected from multiple sources. Utilizing the complete nexo suite allows you to earn interest and borrow funds as you wait for the next trade setup. Visit pro.nexo.io. That's p.r.0.nexo.com and sign up today. This episode is brought to you by Circle, the sole issuer of USDC, and a leader in crypto that's held to a higher standard. USDC is a fast, safe, and efficient way to send money around the globe. USDC is always redeemable one-to-one for U.S. dollars and has over $45 billion in circulation as of October 13, 2022. Plus, Circle posts weekly reserve reports and monthly attestations of reserve capital, letting users know that USDA is safe, transparent, and compliant with regulations.

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Timmeros. Timmeros piece confirms that we have another 0.75% hike coming up, but was substantively all about the discussion of whether there might be a pivot soon. Nick quoted Fed Governor Christopher Waller in a speech earlier this month when he said, quote, we will have a very thoughtful discussion about the pace of tightening at our next meeting. Nick writes, some officials have begun signaling their desire to both slow down the pace of increases soon and to stop raising rates early next year to see how their moves this year are slowing the economy. They want to reduce the risk of causing an unnecessarily sharp slowdown. Others have said it is too soon to have those discussions because high inflation is proving to be more persistent and broad. Jumping down, Nick

continues, Mr. Evan said he would prefer to find a rate level that restricted economic growth enough to lower inflation and hold it there, even if the Fed faced, quote, a few not so great reports on inflation. Evan said, I worry that if the way you judge it is, oh, another bad inflation report, it must be that we need more rate hikes. That puts us at somewhat greater risk of responding overly aggressive. The point here that markets are reading into, of course, is that while the size of the interest rate hike is all but confirmed, Timoros is largely viewed as the best vessel that the market has in understanding where the Fed's head is at. Given that he dedicated all of the words in this piece to growing debate and growing concern

about overcorrecting, markets are saying, hey, that must be where the Fed's head is at as well. So going back to Twitter, as I mentioned, some argued that the Bank of Japan's actions were actually coordinated in some way with this quote-unquote leak from the Fed via Nick Timoros on the Wall Street Journal. Lawrence McDonald tweeted, Friday was a significant day. Bank of Japan intervention and a Federal Reserve policy path shift, it was an inside job. Three things you need to know. No coincidences on Friday. The White House wants equities running higher in the precious 20 days heading into the midterm elections. Bank of Japan, after their first currency intervention failed, they panicked, brought in the U.S. Federal Reserve for much-needed support in round two.

spectacular, quote, developed markets, foreign exchange moves are something you may see once or twice in a lifetime. Story after story will be planted by the Fed. Financial stability risks are too high. The sales pitch has turned. The headline says it all. It's no accident that heading into the quiet period, which started Friday evening, the Fed started to lay out a policy path shift to support asset prices. Lin Alden sums this up. Lawrence proposes that yesterday's partial softening of Fed rhetoric around rate hikes starting in December and the Bank of Japan's currency intervention were coordinated.

Wait Capital writes, see I told you the dollar was peaking. If the BOJ does the biggest currency intervention in decades, the Fed telegraphs through the criminal minds at the Wall Street Journal that they'll pause, and OPEC's positioning is too bullish, the dollar, and bearish, the stocks. Travis Kling writes, this is what global central bank coordination looks like. Wake up this morning in treasury markets looking quite shaky. A couple hours later, Fed mouthpiece throws the market a bone. A couple hours after that, BOJ steps in to support collapsing yen.

incredibly fragile situation. Trader Alex Kruger writes, Japan to the Fed, stop hiking so aggressively or we will be forced to ramp up U.S. Treasury sales. Do wonder if that conversation took place in some form. Also, did the Timoros Wall Street Journal, quote-unquote, leak give Japan a green light to intervene?

Now, a lot of people think this is just ridiculous. Paulo Macro writes, guys, none of the JPI interventions were coordinated. Can we please stop this? The morons who never traded an intervention need to go somewhere else, please. Yes, the BOJ is on the offer at 149 right now. No, the Fed isn't in on it. Please go elsewhere. Regardless of how coordinated this is, let's move back to the Fed and the Timoros piece for just a minute.

There are a couple more things that are notable from this article. The first is that it definitely isn't making it clear that some pivot is guaranteed. Quote, one challenge is that some of the strongest support for slowing down increases comes from so-called policy doves, who have traditionally favored easier monetary policy. Last year, those officials argued most forcefully for waiting to remove stimulus policies. Now with inflation running near a four-decade high, it could be harder for their arguments to gain traction, said Neil Duda, an economist at research firm Renaissance macro. Said Mr. Duda, quote, at critical junctures in the monetary policy decision-making process, they've been spectacularly wrong. The doves are in the penalty box. There are cost to being

wrong at key turning points over the last 18 to 24 months. End quote. What's more, the piece argues in some ways that the market's desperation for reacting to signals for pivots is actually making pivots less likely, said Kathy Bosjannock, chief U.S. economist at Oxford Economics. If officials decide to raise rates by 0.5 points or 50 basis points in December, they would have reason to worry about triggering another market rally. The equity market has been so eager to see pivots by the Fed. Fed officials have to explain that 50 basis points is still a meaningful increase. They keep jumping ahead to the last pivot and were a long way from the Fed cutting rates. Nick's piece goes on. The July rally reversed part of an earlier run-up in mortgage rates, which in turn supported a rebound

in the housing market. If another market rally erupted this fall, the Fed might have to raise rates more than anticipated to slow down the economy, said Jason Furman, a Harvard University economist who served as a top advisor to former President Obama, said Mr. Furman, quote, The last thing you want is to raise rates even more to undo all that. Macro Alf made this same point on Friday on Twitter. This pivot whisper is a terrible idea, he wrote. One, it loosens financial conditions, which will require the Fed. to soon talk tough again. Credibility anyone? Two, it steepens the curve and sends 30-year yields to the moon increasing systemic blow-up risks in derivatives and housing. Not smart. So we've got two things going on

right now just to sum this all up. On the one hand, you have a central bank in Japan who is actively intervening or at least appears or is widely seen to be actively intervening in their currency markets in a way that they haven't for decades. This has made all the more interesting based on the fact that a lot of the mechanism for that intervention is using their foreign exchange reserves, i.e. U.S. treasuries, to defend the price of the yen. People are looking at it then not just as an example of a central bank in a developed economy taking the extraordinary action to try to defend their currency, but also wondering about the implications for the U.S. Treasury market. Meanwhile, in the U.S., you have the Fed's chosen mouthpiece for signaling potential shifts in their thinking,

in Nick Timoros at the Wall Street Journal, throwing the market a bone, as Travis Kling put it. The piece in no way reads like it's a full steam pivot ahead, but to the extent that it was intentionally crafted to give the Fed some narrative space, it certainly is giving more credence to the we don't want to go too far and we want to see the impact that our rate increases have already had perspective in the Fed. Now, layering an interesting meta-game dimension on top of all that, that piece from Timoros concludes with the concern that if the market makes too much of the signal, the Fed is going have to get even tougher again as a response.

Ergo, there is this incredibly delicate dance, this tightrope act that the Fed is walking where it wants to give itself more options going into the fall in the winter, but not so much that the desperate hungry markets overinterpret the signal and force their hand back the other direction. And while it's tempting at this point to groan and massage one's temples at the stupidity of a system that reads tea leaves in Wall Street Journal articles like their prognostications from the oracles of old, it is the system we have right now. So here we are. Anyways, guys, we are off to another interesting week, if nothing else. For now, I want to say thanks again to my sponsors, next to dotio, circle and FTX. And thanks to you guys for listening. Until tomorrow, be safe and

take care of each other. Peace.