NY-Based VC Explains Why a Rising Japanese Yen Is Causing Risk Assets Including Crypto to Crash

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As a seasoned researcher with over two decades of experience in financial markets, I find Jonathan Wu’s analysis of the cryptocurrency market and its ongoing crash to be insightful and well-grounded. His emphasis on carry trading and its inherent risks, as well as his focus on the role of Japan’s monetary policy, particularly the Bank of Japan (BOJ), provides a comprehensive understanding of the current market dynamics.

Today, I, as a researcher, am reflecting upon the recent downturn in the cryptocurrency market, a topic recently discussed by Jonathan Wu, an investor at Asylum Ventures, a venture fund based in Brooklyn, New York, with a $55 million early-stage focus. He shared his insights on this matter through a series of posts on a social media platform.

Wu initiated his discussion by focusing on the basics of carry trading, a method in which investors loan funds at relatively lower interest rates using one currency, and then invest those funds in assets offering higher returns from another currency.

In a carry trade, investors take advantage of differences in interest rates between various currencies by borrowing money at lower rates in one currency (like the Japanese Yen or Swiss Franc) and using it to buy assets in another currency (such as the US Dollar or Australian Dollar) that have higher interest rates. The aim is to earn profits from the gap between the low cost of borrowing and the increased returns on investments in these high-yielding currencies, which can be bonds, stocks, or high-interest deposits. Essentially, they are exploiting the disparity between the costs and benefits offered by different currencies.

As a seasoned investor with years of experience under my belt, I have found that carry trading can be a lucrative strategy when exchange rates and interest rate differentials remain stable or move favorably. However, this approach is not without its risks, and I’ve learned this the hard way in the past.

As per Wu’s explanation, there are three key prerequisites that must be in place for this strategy to thrive: affordable loan interest rates, substantial collateral value, and lucrative investment opportunities. However, Wu pointed out that these conditions have been weakening for carry traders, which could potentially lead to major market turbulence.

A substantial portion of Wu’s study centers around the Bank of Japan (BOJ) and their recent modifications in monetary policy. Wu argues that due to inflation concerns, the BOJ has felt pressured to tighten its monetary policy, similar to the Federal Reserve’s series of interest rate increases from 2022 to 2023. Wu points out that a depreciated Yen, combined with Japan’s status as an import-reliant, resource-scarce nation, complicates their ability to control foreign trade effectively.

According to Wu’s explanation, in an attempt to address rising prices (inflation), the Bank of Japan increased interest rates. Essentially, this means it became costlier to borrow money, which in turn lessened the amount of money circulating due to loans becoming more expensive. This action was taken to control inflation but had significant implications for carry traders.

Wu discussed the struggle faced by carry traders who had taken out loans in Yen to buy foreign assets. As interest rates went up, it boosted the worth of the Yen, causing significant problems for these traders. Wu clarified that higher interest rates led to a greater desire for Yen due to better returns, which in turn made the currency stronger. This increase in demand also raised the cost of borrowing in Yen, leading to a decrease in the money supply and further enhancing the strength of the Yen.

Wu noted a substantial increase in the Yen’s worth, as the US Dollar to Japanese Yen exchange rate fell from its peak at 162 down to 145 (currently standing at 142.38).

The increase in the value of the Yen led to a heavier burden for those with yen loans in USD terms. Wu pointed out that the increased debt and higher interest rates made some traders sell their assets to repay their loans, which boosted the yen further, creating a cycle where liquidation and currency appreciation feed into each other.

Using cryptocurrency markets as an analogy, Wu highlighted how self-reinforcing patterns significantly impact market behavior. He drew a parallel between the current state of affairs and the collapse of Terra, stressing that while things seem stable during favorable conditions (like a cheaper Yen), they can quickly deteriorate when circumstances change.

As a crypto investor, I’ve come to understand that the hidden leverage in our financial system, fueled by Japan’s monetary policy, has been a major factor driving the valuations of risk assets. Now, with the Bank of Japan tightening its policies, I see this leverage being gradually unwound, and it’s creating ripples across various markets, including cryptocurrencies.

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2024-08-05 15:31