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Japanese institutional managers – known for their famous US debt buyouts in recent decades – are now fueling great bond selloffs as the Federal Reserve crosses its $9 trillion balance sheet.
The latest data from BMO Capital Markets shows the largest foreign holder of the Treasury has withdrawn nearly $60 billion in the past three months. While this may be a small change relative to Japan’s reserves of $1.3 trillion, disinvestment risks increasing.
This is because the monetary trajectory between the US and the Asian nation is turning more, the yen is hitting a 20-year low and market volatility is breaking out. All that is driving up currency-hedging costs and completely offsetting the appeal of higher nominal US returns, particularly among large life insurers.
The upshot: Japanese accounts are contributing to the historic Treasury route and may not collectively return until the benchmark 10-year yield trades strongly above 3%. In fact, near-zero-yield bonds on the home look more attractive, even though American loans offer some of the highest rates in years.
“This is a significant amount of sales and is on par with what we saw from Japan in early 2017,” said Ben Jeffery, rates strategist at BMO.
While an aggressive Fed tightening cycle to tackle inflation could result in several 50 basis-point increases in the coming months, the Bank of Japan remains locked in endless stimulus. It is weakening the yen and lifting the economics of treasury buying, even as 10-year Japanese government bonds capped around 0.25%.
While the 10-year US yield traded at 2.91% as of 6:55 a.m. in New York, buyers who pay to protect against yen-dollar exchange rate fluctuations saw their effective yield fall to just 1.3%. This is because hedging costs have risen by 1.55 percentage points, a level not seen since early 2020 when global demand for the dollar increased during the pandemic.
A year ago the Treasury benchmark was offering a similar yield, thanks to a modest 32 basis-point hedging cost, when accounting for the cost of the security against exchange rate moves.
“Hedge cost is an issue for investments in US Treasuries,” said Eichiro Miura, general manager of the fixed-income department at Nisse Asset Management Corp.
The Fed’s tight cycle and associated market volatility have affected Japanese purchases of Treasuries in the past. But in this cycle, higher levels of uncertainty around US inflation and interest rate policy could trigger an extended absence. Also, Japanese traders returning from the Golden Week holiday have other offshore options as euro-hedging costs remain close to the one-year average.
“Over the next six-month period, investments in Europe do better than the US because hedge costs are likely to be lower,” said Tatsuya Higuchi, executive chief fund manager at Mitsubishi UFJ Kokusai Asset Management Company. Looking at the spread, Spain, Italy or France look attractive among Euro bonds. ,
Typically, Japanese purchases favor the intermediate regions of the Treasury curve with five- to 10-year notes, while life insurers and pension funds focus on 30-year bonds. But the new fiscal year that begins in April is expected to see a prolonged buyout in the Treasury market, as some large life insurers reconsider their exposure to foreign debt, largely driven by massive monetary shifts. But given the volatility in the currency. US Central Bank.
“The Fed is getting super aggressive,” said John Madzier, portfolio manager at Vanguard Group Inc., “are you really going to buy when the Treasury probably reaches more attractive levels?”
A broader Treasury index is already sitting at a loss of more than 8% so far this year. Much now depends on whether the 10 years can consolidate in the 2.80% to 3.10% range this month, when the upcoming Fed meeting is absorbed by the market with quarterly debt sales from the US Treasury.
“Japanese investors will wait for some stabilization in long-term yields before sensing a buying opportunity,” said Jorge Goncalves, Head of Macro Strategy at MUFG. “If there is a 10-year agreement during May, that will help attract buyers and at those yield levels you are getting compensated right now.”
(Updates the yield level in the eighth paragraph.)
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