Thread by @jonwu_

It seems unintuitive that a small 25 basis point interest rate hike in Japan would spike all risk assets, including tonight's -20% $ETH candle.

But you need to understand the way the carry trade works:

It's a leveraged unwinding.

The quick explanation of the carry trade is borrow at 0 rate and invest in something with higher than 0 expected returns:

1. borrow Yen for nothing
2. buy an asset outside Japan that yields more than nothing
3. ???
4. profit

The same behavior happened during the ZIRP era.

Take a margin loan out against your equities at a 2% variable rate and buy an AirBnB with it that yields 7%.

7% - 2% = 5% of free money, right?! ...right?

Well yes, so long as:
- your borrow rate remains low
- your collateral is worth something
- and the thing you bought with your loan makes money

All those things are becoming not-true for the carry traders.

First, rates.

The Bank of Japan is being forced into tighter monetary policy to protect Japanese people suffering under inflation:

The same killer the Fed was forced to confront when it raised interest rates at a historic pace from 2022-2023.

An already-weak Yen was making it hard for Japanese to buy foreign goods--a very tough spot to be in for a resource-poor country that imports most of its goods.

So in order to combat inflation, the BOJ raised rates.

Recall that interest rates are the price of borrowing money, so if you want less money in circulation, you raise the price of creating money.

To the carry traders borrowing Yen in order to buy foreign assets, this is death.

They own foreign-currency-denominated assets against Yen-denominated loans.

So for someone who OWES Yen and OWNS USD-denominated assets:

JPY:USD ↓ = 😁
USD:JPY ↑ = 😭

Higher interest rates exert upward pressure on the Yen's value:

First of all, they create direct demand for more Yen because now the yield on Yen has gone up, strengthening the currency because more people want to buy and hold it.

Second, it increases the cost of borrow.

Higher borrowing costs = less Yen borrowed = less supply = more upward pressure on the Yen.

As a result the Yen has SPIKED in value--and the inverse measure, USDJPY has fallen dramatically from a high of 162 to 145.

And because the Yen is so much stronger, anyone who was borrowing Yen now owes 10% more in USD terms just over the last few weeks!!

So it's a double-whammy for Yen borrowers:
- your loan outstanding is higher
- your interest rate is higher

The result caused some traders to sell their assets and repurchase Yen in order to pay back their loans.

But that buy pressure against the Yen sends it up further!

Which forces more buying--resulting in a liquidation cascade.

It's funny--in crypto we see these reflexive dynamics play out over and over again.

This is basically how Terra got unwound. We were born into reflexivity.

Everything goes great in one direction (Yen cheaper; I'm richer) and awful in the opposite.

Now we see how over the skis the carry traders were.

It seems folks were making a bet that interest rates would stay at 0 forever, that USDJPY would skyrocket, making the Yen worthless, and that BOJ was willing to enact ever more pain on the Japanese consumer...

And if that's the case we might not even be close to the end of forced selling.

That's the way these cascades go.

Only the folks with horrible risk management get liquidated first, but the building snowball eventually eats up anyone on the wrong side.

This is why risk assets are taking a tumble.

The hidden leverage in the system was the infinite money glitch that was Japan monetary policy.

The BOJ was the piggy bank for the world's assets.

But the piggy bank just closed. And now--pain.

There's a typo here:

JPY:USD ↓ = 😁
JPY:USD ↑ = 😭

Wow this went proper viral. Hi mom!

About me: I'm an early stage investor at @asylumventures

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