Last month’s collapse of TerraUSD’s stablecoin, which promised but failed to maintain a fixed exchange rate to the dollar, heralded the beginning of what may be a new ice age for digital assets.
Now another currency peg looks set to fail. Only this time it could vindicate crypto bulls, as confidence in a traditional central bank appears to be evaporating, with potentially ugly ramifications for Americans.
While Bitcoin bulls are nursing losses as the original cryptocurrency plumbs depths not seen since December 2020, the Japanese yen has fallen even further, marking 24-year lows versus the greenback.
The peg in question is the Bank of Japan’s self-imposed ceiling on the benchmark 10-year government bond that restricts the yield investors earn to no more than 0.25%. This helps pin down borrowing costs across the broader economy and support growth.
Should bond vigilantes dump their holdings overboard in a sign of their dwindling faith, the BoJ steps into the void to buy up excess supply with the help of freshly created yen. This exerts downward pressure on the yield, pushing it back below the central bank’s target level.
The technical term for this is yield curve control, but the mechanics are not much different to maintaining a peg—a line is marked in the sand with the implicit warning to speculators that it will be defended at all costs with the full force and power of the issuer, in this case the BoJ. (The practice may soon be introduced by the European Central Bank to help Italy fend off bond vigilantes of its own.)
“We do think that the BoJ will be forced to capitulate at some point,” Russel Matthews, senior portfolio manager at hedge fund BlueBay, told Bloomberg Television, justifying a “sizable short” on Japanese government bonds.
‘Between a rock and a hard place’
While the foundation behind TerraUSD burned through almost its entire reserves of Bitcoin in a failed attempt to prop up its fixed exchange ratio, the BoJ can in theory print unlimited amounts of money to cap yields on government debt.
Now it appears speculators are set to test its resolve much the same way they attacked TerraUSD, eventually sending South Korean creator Do Kwon’s stablecoin into a death spiral from which it never returned.
“The bond market appears to be pricing in the chance of a collapse in yield curve control,” wrote Jun Ishii, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, in a research note.
The unique problem the BoJ faces is that it can defend the peg by flooding the market with freshly created money, thereby sending the yen into a potentially uncontrolled tailspin, or it can defend its currency as an immutable store of value—but it cannot do both, and the market is forcing it to make a choice.
“The Bank of Japan increasingly seems to be caught between a rock and a hard place,” predicted NN Investment Partners senior economist Willem Verhagen before the peg was tested this week.
Tensions running high
That is, unless it picks a third option—and this is where risks emerge for America’s economy.
Given Japan’s role as the largest foreign owner of U.S. government debt, with an estimated $1.3 trillion in reserves, the dollar could come under pressure if Tokyo starts liquidating its holdings to prop up its own currency.
“Tokyo could intervene if the yen slides below 135 to the dollar and starts going into a free fall. That’s when Tokyo really needs to step in,” said Atsushi Takeda, chief economist at Itochu Economic Research Institute in Tokyo, last week.
If it did, it would mark the Japanese government’s first intervention in currency markets in over a decade. BoJ governor Haruhiko Kuroda is set to announce his plans tomorrow.
“Tension is heightening toward Friday’s BoJ decision,” Katsutoshi Inadome, a strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo, told Bloomberg on Wednesday.
A failure of confidence in one of the world’s premier central banks would vindicate crypto bulls who believe community-driven governance—of the sort found in the management of cryptocurrencies—can create better outcomes than can a small committee of unelected and unaccountable central bank policymakers.
Last man standing
At its heart, the move toward currencies like Bitcoin started out as a reaction to central banks actively debasing their fiat currency by flooding the market with new money created at the touch of a button.
Called quantitative easing (QE), the aim was to counteract the deflationary effect from Wall Street repairing its balance sheet that had become overburdened by debt during the financial crisis. Effectively, central banks were levitating the economy through sheer will.
Speculation aside, the crypto bull run of the past few years was therefore an implicit message from investors they had lost faith in the powers that be and sought to unplug themselves entirely from the centralized finance system. Instead they would take ownership over their affairs by shifting to assets like Bitcoin, which MicroStrategy CEO Michael Saylor repeatedly argues is the hardest currency the world has ever seen.
On Wednesday, Deutsche Bank’s head of thematic research, Jim Reid, argued the BoJ peg is becoming increasingly expensive to maintain with the yen plummeting 20% in value since March: “They are becoming the last man standing on QE.”
And while he views a capitulation by the BoJ as a low-probability outcome, it nevertheless poses a high risk for global interest rates.
“It’s the first thing I look at every morning when I wake up,” he wrote in a research note.
