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I love grandiose plans and complicated schemes fraught with deception, backdoor deals, and intrigue. Even better if there is some reality to the story. Arthur Hayes recently wrote a wonderful set of essays that turn mundane central banker activity into the center of politics, power, and international deals for the benefit of the established political class.

Hayes starts with an argument that policy makers will always prioritize getting reelected. Actions or policies that are hard in the short term, but optimal in the long term get scorned for short term gain, at future cost.

In this case the policy makers in his scope are the US Federal Reserve, Treasury, and Democratic Party. The short term gain they are seeking is reelection and maintenance of power come November. The future cost is a devaluation of the US Dollar, inflation, and a further divide between those that own assets and those that do not.

What is the issue? Well there are actually a couple. This isn’t your generic single issue story, remember. It is full of actors, conflicting motives, threats of mutual destruction, and deals to maintain power.

These are the players and motives Hayes lays out in his writing:

First, the US Treasury and Democrats, who want to run a large fiscal deficit without bond yields going up.

Second is Japan, who wants to strengthen the Yen without raising yields on JGBs (a traditional developed market way of supporting the currency). The next best option is selling USTs for Dollars, so they can sell the Dollars and buy Yen.

The final character is China, who wants Japan to strengthen the Yen so its exports remain competitive. However, China doesn’t want to devalue vs the Dollar.

Conflicts abound. The United States must ensure Japan doesn’t start selling USTs (they’re the largest foreign holder) to prop up the Yen. China needs to get diplomatic and convince the US that their interests are aligned- maintain power and placate the masses- when it comes to strengthening the Yen and devaluing the Dollar.

The ‘easy button’ is whatever makes everyone happy and maintains the status quo. If someone is unhappy, they might shake the boat, and that could make everyone very unhappy.

‘Merica

Land of the free, home of the brave, where we take what we want, and you don’t have a say.

As the entire global financial system is US focused, we will start with the hegemon’s motives, and the consequences of failure.

The Treasury and Democrats want to issue lots of debt to fund their fiscal deficit, which keeps the economy humming along and the citizens content. Pet projects get funded, growth is all but guaranteed, and the difficulties of cutting spending to balance the budget is handled on a later day.

Selling this debt without lowering the price (thus raising rates) is getting hard, though. Some might say confiscating Russian assets and government projections of a runaway federal deficit are contributing.

As the UST market stands, the Treasury is not having issues selling new debt at current prices. The concern, explicitly voiced by Jay Powell, is that a large holders decides to sell down their stash. If that happened… there would not be enough buyers, fear of inflation returning would be heard in every bar and tavern, and the odds of the incumbents come November would get a lot worse.

After this exact scenario played out during the initial COVID market panic, the Fed implemented a foreign repo facility. This ‘allowed’ foreign central banks to swap USTs for much needed cash, without selling the USTs on the open market and pissing off the king. In the June 2020 Monetary Policy Report they wrote:

“The Federal Reserve coordinated with other central banks to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements and announced the establishment of temporary U.S. dollar liquidity arrangements (swap lines) with additional central banks. The Federal Reserve also established a temporary repurchase agreement facility for foreign.”

The Fed already has a standing repo facility for US banks and institutions, so a liquidity issue there can be controlled. If the US and foreign central banks all have access to the repo facility, problem solved, right?

Wrong.

Japanese banks, pensions, and institutions own a large amount of USTs. Unfortunately for the Treasury and these banks, their USTs are deeply underwater AND costing a lot to hedge currency risk.

Japan

As mentioned earlier, the issue for the Treasury as of writing isn’t a lack of buyers for new bonds, it is a lack of buyers for old bonds sold in size. This seller has begun to emerge in Japan, where the large Norinchukin development bank announced it will be selling 63 billion USD worth of US and European government bonds.

Hayes argues in Shikata Ga Nai that all Japanese banks are in a similar position to Norinchukin, and this is just the first shoe to fall, so while the UST sale amount is not that large, it could quickly add up if other banks begin selling.

Nikkei Asia writes, “According to the U.S. Treasury Department, Japanese investors held $1.18 trillion of U.S. government bonds as of March, the largest slice among foreign holders. Massive sales by Norinchukin could have a sizable effect on the U.S. bond market.“

Selling the bonds is the last resort for these banks- none of us like to realize losses. The heart of the issue is currency risk, Hayes explains.

If a Japanese company was buying Japanese bonds, there is no currency risk, everything is in Yen. When a Japanese company buys USTs, however, there is a currency risk. They will get Dollars when the bonds mature, and will need to sell those to buy Yen. If the Yen has appreciated against the Dollar during the holding period, there could be a substantial loss on the exchange.

Banks are obligated to manage risk by hedging their position. The hedge negates future currency risk, but comes at a cost. That cost has become prohibitively high due to the UST/ JGB yield differential (Hayes says, and I take his word for it). The cost is so much that it makes more sense to sell the USTs that are down 20-30% for a loss, just to stop losing money on the currency hedge.

I believe this explanation because it is logically sound. If the issue was only unrealized losses, the bank would simply hold the USTs to maturity. Something worse is going on here, and a suddenly costly currency hedge makes sense.

That isn’t Japan’s only thread in this story. An additional twist is added when one considers the dual sell off in the JGB and Yen. Protecting the currency is priority #1. If the Yen is allowed to fall too much, Japanese savers will become fearful and start selling their currency for something, anything else. Once that point is reached, a vicious feedback loop can start, where selling begets sell-off…

Japan’s favorite way to strengthen the currency is to start selling Dollars and buying Yen in gigantic quantities, unannounced (known as a Yentervention). This is preferable to alternatives because there is no need to raise interest rates. Japan’s Ministry of Finance doesn’t have a USD printing press however, so they need USD to continue down the path of Yenterventions (yield curve control).

An easily accessible pool of USD can be accessed by selling USTs. If the US doesn’t want this to happen they need to offer an alternative.

The Deal

The US Treasury and Fed can control how the selling takes place, and they will if Hayes’s theory is correct. They can do this using a three step process. First, they inform the BOJ to buy all USTs Japanese institutions wish to sell at market price. The BOJ can do this with USD or Yen, I think, so they will choose Yen which they can create. Once they have the USTs, they pledge them to the Fed’s foreign repo market that the Fed conveniently created in 2020, and get Dollars in return.

UST yields stay steady, Japanese banks get to unload their toxic carry trade. The banks still lose money on the sale, and US citizens are financially repressed as interest rates are held below the free market rate.

With this deal, Japan still has a currency problem, but that what the other tool mentioned in the Fed’s 2020 Monetary Policy Report is for. Aside from owing Japan one for not selling USTs on the open market, why would the Fed help Japan? For the next puzzle piece, we turn to China.

The Frenemy

Unfortunately for the the US political powers that be, China is also scared of getting screwed by Japan. The extremely weak Yen pisses them off because Japan is their biggest export competitor. When the Yen devalues vs the Yuan, Japanese exports become cheaper for foreign countries, leading to a drop in Chinese exports. China could theoretically devalue, but that becomes a race to the bottom. For a host of reasons, the ideal scenario for the Yuan and China is to weaken against the Yen without devaluing even more against the US Dollar.

This is where we get to the real intrigue, web of motives, and backdoor deals. Hayes hypothesizes that China will ask the US to help Japan strengthen the Yen.

For the moment let us set aside the question of whether or not the US would go along with this request, and just focus on how this could be done.

As discussed earlier, the preferred way to do this is by selling Dollars and buying Yen, NOT by raising interest rates, which would make BOJ JGB buying more costly.

But Japan can’t sell USTs to get Dollars without really pissing off the US, and have limited foreign reserves to spend. Where do they get the Dollars?

The easy button in this case is the Fed and BOJ agreeing to a gargantuan swap line! Hayes convincingly explains how trivial a large currency swap would be to execute. Let’s explain.

Central Bank Currency Swap

The swap works as such: The Fed send the BOJ or MOF Dollars, and they send the Fed Yen (all created by computers, of course). The BOJ/ MOF can then sell the USD to buy Yen, which will strengthen the currency and make best bud China happy :D. The Fed just holds the Yen in their piggy bank, so it has no effect on the market.

Once the BOJ has started selling USD, China can begin stimulating an equivalent amount. This should keep the USD/CNY steady as both countries are expanding monetary supply by the same amount. Since the Yen is just sitting in the Fed’s cold storage, it is the only currency not being devalued.

Here is a quick summary of each countries (leader’s) desire, pertinent effect of the swap, and the sacrifice they have to make for continuing the global status quo.

	Want	Sacrifice	Swap Effect
United States	Continuation of Global Financial System & low UST yields	Doing what China wants	Devalues USD & increases supply
Japan	Slower Yen devaluation & low JGB yields	Doing the US bidding & helping support the UST market	Gives USD ammo to strengthen Yen
China	Stronger Yen & stimulus without devaluation vs USD	Asking a favor from the US and risking true decoupling	Makes Chinese exports more competitive

Despite all the posturing against China that is politically popular right now, we are still dependent on them, and them on us. A break would lead to crushing inflation in the West, and a severe recession starting in the East and quickly enveloping the globe.

For political leaders who are always thinking in the short term, it makes sense to strike this deal. The sacrifices are small, and they get to keep on keepin’ on.

The Big Picture

Earlier we set aside the question of US policy maker’s appetite for working with China. The request to strengthen the Yen is both inline with what Japan wants, and the Fed’s power. Hayes reiterates the ‘easy button’ for US politicians is cooperation.

In the off case someone in the US wants to be a hero, and denies China’s polite request to strengthen the Yen via a swap line, Hayes argues China could convincingly threaten the nuclear option: full withdrawal from the USD system.

He outlines this scenario as follows. First, China would sell as many USTs for gold as it can before accounts get frozen a-la Russia (this would be an act of war in the eyes of the US). Next, China establishes a ‘dirty peg’ between gold and Yuan. Increased demand for gold in the East will pull gold from the West.

The early ramifications of this would be an explosion in the gold price, and if speculation about uncovered short selling by Western financial institutions is true, lead to a lot of people losing a lot of money. It’s safe to say the potential for a cascade of defaults and unwinding of credit would be higher than usual.

As the Democratic Party, Treasury, and Fed would like to maintain the status quo, Hayes convincingly argues they will take China up on the first offer- a USD/Yen swap line, which devalues the Dollar, strengthens the Yen, and allows China to stimulate.

And We All Live Happily Every After

Hayes offers a few ways to monitor this thesis and a resounding, ‘buy crypto’ conclusion. To monitor the central bank swap line, read the Fed balance sheet and look for “Repurchase Agreements – Foreign Official.”

The crypto bull market call is based on increased USD liquidity, thanks to the swap line.

Finally

The matrix of motives and maneuvering by politicians and bankers that Hayes weaves is outstanding because it makes his theory fun. His well informed opinions and experience working within the financial system from Hong Kong gives him more credibility than your usual macro speculator.

Most importantly though, his foundation is strong. Those in power really do want to retain that power, and they will choose the easy way nine out of ten times. The desire for limited low JGB and UST yields is undeniable, just as the Yen weakening undoubtedly hurts Chinese exports.

Using an already established mechanism of central bank currency swaps and the Fed foreign repo facility, the US can control the UST yield curve, Japan can strengthen the currency without raising interest rates, and China maintains export competitiveness with Japan and Yuan strength vs USD.

If Hayes’s Theory of the Swap is correct, it will be a good reminder of how long the decoupling between East and West will take, and the political expedience of cooperation.

Thanks to Mr. Arthur Hayes for writing without a paywall, and all the public servants who keep things running smoothly, because, in the end, maybe it isn’t such a bad thing they have more tricks up their sleeve to maintain the status quo.

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