Column-Bank of Japan shift exposes global bond cracks: McGeever

By Jamie McGeever

ORLANDO, Fla. (Reuters) – Japan risks pulling the rug from under the much-touted “year of the bond.”

Further changes to the Bank of Japan’s yield curve control (YCC) policy could bring more Japanese money back home, against a backdrop of rising hedging costs that are already weighing on domestic investors’ demand for overseas bonds.

The jump in Japanese bond yields is being offset by lofty short-term U.S. and euro zone yields, which are inverting these yield curves and making it more expensive for Japanese investors to hedge their exposure to Treasuries or euro zone bonds.

Japan is the world’s largest creditor, with a net investment position of $3.2 trillion, according to the International Monetary Fund. Japanese investors hold a lot of foreign bonds – some $4.3 trillion in various debt instruments, of which $2.085 trillion is “portfolio investments.”

Around half of that is in U.S. assets such as Treasuries, agency debt and corporate bonds, and around a third in euro zone securities. Unloading even a fraction of them could have a discernible impact on flows, prices and yields.

This is what observers might be anticipating if the BOJ on Wednesday modifies its YCC policy again – or even abandons it completely – after stunning markets last month by effectively raising the cap on 10-year government bonds to 0.50% from 0.25%.

A blog published on Monday by Brad Setser, an economist who is a senior fellow at the Council on Foreign Relations, and Alex Etra, senior strategist at Exante Data, argues that long-dated Japanese government bonds are already attractive relative to hedged returns on investment grade foreign bonds.

Wholesale liquidation of Japanese investors’ foreign bond holdings is unlikely barring a “very substantial” rise in Japanese yields from here. The reality may be less eye-catching, but no less powerful over the long term.

“The most likely outcome in 2023 is a continuation of the roll down in Japanese holdings of foreign bonds observed in 2022, as the large pool of hedged Japanese investors allow maturing bonds to roll off at par rather than reinvest abroad,” they wrote.

“That more mundane reality still implies the large flow into global fixed income from Japanese institutional investors over the last decade will dwindle to a relative trickle,” they added.

Graphic 2: Japanese holdings of overseas bonds,https://fingfx.thomsonreuters.com/gfx/mkt/egpbymqnmvq/Setser1.jpg

Graphic 1: Japanese investments in foreign assets (yearly data), https://fingfx.thomsonreuters.com/gfx/mkt/dwpkdaaxyvm/Japanese%20investments%20in%20foreign%20assets%20yearly.jpg

Hedging costs

Japanese investors of all stripes – life insurers, pension funds, banks and households – have piled into overseas bonds over the last 20 years or so because foreign interest rates and yields were far higher than those on offer at home.

Cumulative purchases from Japan’s private sector since 2000 reached a high of $2.5 trillion in 2021.

Graphic 4: Japanese holdings of foreign bonds – total, https://fingfx.thomsonreuters.com/gfx/mkt/gdpzqwbrevw/Setser3.jpg

Unhedged purchases were especially attractive if they were not blindsided by exchange rate moves. Currency-hedged returns were still positive, but rising U.S. and euro policy rates and short-term yields have changed all that.

Currency hedging is done through FX and interest rate derivatives markets, and generally boils down to borrowing on a short-term basis to buy longer-dated securities.

An inverted yield curve pushes forward currency rates below current spot rates, meaning investors that have locked in their dollar or euro exposure face losing out when they eventually swap those currencies back into yen.

Graphic 3: Hedging costs for Japanese investors, https://fingfx.thomsonreuters.com/gfx/mkt/dwvkdalgzpm/Setser2.jpg

Last year, Japanese investor selling picked up pace as U.S. and euro zone borrowing costs rose. Setser and Etra estimate that foreign bond sales probably neared $200 billion.

For unhedged investors, recent exchange rate moves and volatility have been most unwelcome. The yen has surged almost 20% against the dollar since hitting a 30-year low in October, propelled by the BOJ’s YCC move and three bouts of yen-buying intervention in September and October worth $60 billion.

Hedged investors have cut back their exposure to foreign bonds, particularly banks and now life insurers, according to Setser and Etra.

Analysts at JP Morgan estimate that the nine major Japanese life insurers sold around 2 trillion yen of euro-denominated bonds in the April-September period last year. More sales could be coming.

“We should pay close attention to the monthly flow data going forward given their presence in the euro government bond market,” they wrote last month after the BOJ’s shock yield cap move.

(The opinions expressed here are those of the author, a columnist for Reuters.)

(By Jamie McGeever; Editing by Paul Simao)