The hidden danger behind the Fed rate cuts

Federal Reserve chair Jerome Powell announced last week that the US central bank was ready to cut federal interest rates.

That should certainly be good news for risk-on assets like Bitcoin and tech stocks. However, BitMEX co-founder Arthur Hayes argued in a Wednesday blog post that the move risks triggering a repeat of a Japan-led market panic.

“We are forgetting that these future anticipated rate cuts by the Fed, Bank of England, and European Central Bank reduce the interest rate differential between these currencies and the yen,” Hayes wrote.

“The danger of the yen carry trade unwind will reappear and could derail the party,” Hayes said.

Yen carry trade

Investors take advantage of Japan’s low interest rates to borrow yen and buy high-performing US equities and bonds — a strategy called the “carry trade.”

At the end of July, the Bank of Japan announced that it would raise interest rates to combat inflation. The decision caused a global market panic on August 5, as it meant that investors would have to sell their US holdings to pay interest on their borrowed yen.

On that day, Japan’s Nikkei and Topix — the country’s two biggest stock market indexes — closed down more than 12%, marking their worst day since the 1987 market crash.

The S&P 500 and Nasdaq dropped 4.2% and 6.3%, while Bitcoin and Ethereum briefly plunged 15% and 20%, respectively.

While Hayes said the BoJ “caved” by announcing it wouldn’t raise rates any further, he stated markets could still be in danger if the yen were to strengthen meaningfully against the US dollar.

That’s because investors operating the yen carry trade will suffer losses if they end up having to pay back 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 that pattern when US interest rates ease. In both cases, the dollar/yen interest rate differential narrows.

“If cutting rates of three of the largest global economies strengthens the yen vs. their domestic currencies, then we should expect a negative market reaction,” Hayes wrote.

And that reaction will likely “overwhelm” any benefits obtained from the US rate cuts, he said, because “the amount of global financial assets financed in yen is in the tens of trillions of dollars.”

Risky solution

If the carry trade does unwind as a result of lower interest rates, the US central bank will likely respond by propping up markets with additional liquidity, Hayes said.

First, the Federal Reserve will end its quantitative tightening programme — through which it has shrunk its balance sheet, thus removing liquidity from the system — and, second, 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, could draw down the $740 billion left in the Treasury General Account, which acts as the department’s checking account.

All of this activity will likely exacerbate inflation, Hayes said

“For assets in finite supply like Bitcoin, it will provide a trip at lightspeed to the moon!” he wrote.

Tom Carreras is a markets correspondent at DL News. Got a tip about Bitcoin and macroeconomics? Reach out at tcarreras@dlnews.com