Global bond investors’ biggest fear is coming true

NOW that traders have an idea of who will likely take over the Bank of Japan’s (BOJ) governorship, their focus will shift to global bond investors’ biggest worry: a wave of Japanese cash flowing out of international markets towards rising yields at home.

Local bond yields climbed after surprise news last Friday (Feb 10) that economist Kazuo Ueda looked set to enter the central bank’s hot seat. This sent Japan watchers scrambling to determine whether he would be a hawk or dove. Beyond the yield volatility that any policy decision could trigger, the steady selling of overseas bonds in favour of Japanese alternatives has begun in earnest and looks unlikely to stop.

Japanese investors offloaded a record US$181 billion of foreign debt, and poured 30.3 trillion yen (S$304.5 billion) into their government bond market, the latest data from the Ministry of Finance and Japan Securities Dealers Association showed.

Global investors need to worry if Ueda removes the BOJ’s cap on yields because there are still overseas bonds worth more than US$2 trillion that could be sold.

Benjamin Shatil, head of Japan forex strategy at JPMorgan, said: “Our forecast anticipates a sustained shift in Japanese portfolio flows this year from overseas to domestic debt.

“This shift, we believe, is being prompted, in part, by a view that sustained price and wage rises will inform further relaxation of the yield-curve control policy and greater BOJ tolerance for domestic yield rises.”

Japanese investors were net sellers in about 70 per cent of 20 major global fixed-income markets through late 2022, he added, with the largest outflows in Europe and Australia.

The chance of higher Japanese yields causing a destabilising spillover into global debt markets gained traction last December. Then, a modest tweak to the BOJ’s ceiling for the 10-year benchmark sent the yen higher and Treasuries lower. The move touched everything from US equity futures to the Australian dollar and gold.

Japanese investors own more than US$1 trillion of US Treasury securities, in addition to significant amounts of bonds from Australia, France, the Netherlands and the UK.

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Amir Anvarzadeh, a strategist at Asymmetric Advisors in Singapore, said: “When they finally let rates go, domestic institutions in Japan who’ve been waiting and waiting for higher returns could pounce on Japanese government bonds.” Anvarzadeh has tracked Japanese markets for three decades. 

The concerns will have global bond investors keeping a watchful eye on the nomination of governor Haruhiko Kuroda’s replacement on Tuesday.

Regardless of whether Ueda turns out to be a hawk or a dove, those worried that new management could catalyse further Japanese outflows from overseas assets have reason to be fearful. Should he shift policy and drive Japanese yields higher, their increased relative attraction is sure to tempt the country’s giant insurers and pension funds to accelerate a return of cash home.

But even if Ueda keeps policy changes to a minimum, that is just likely to renew last year’s pressure on the yen and feed into its onerous hedging costs, another key catalyst for last year’s Japanese overseas bond outflows.

With those costs still sky-high, even Japan’s artificially capped 10-year yield of 0.5 per cent is more attractive to a local fund manager than the minus 1.3 per cent yen-hedged yield they would get from equivalent Treasuries.

The heightened scrutiny over the investment plans of some of the world’s biggest fixed-income investors comes at a time when the global bond market is back under pressure. Yields have started to climb once more, as expectations for peak US interest rates grind higher on robust employment data and fears that inflation may not be quickly vanquished.

Jeff Brunton, head of portfolio management at Australian pension fund Hesta, said it would be a “delicate balance” to find between the BOJ and bond market, “so that Japan can acknowledge that maybe they are exiting the need for ultra-low or negative interest rates”.

“But it does need to be done in a really transparent way, with a clear set of criteria signals to the marketplace, because we don’t want it to be a destabilising moment for global bond markets,” he noted.

For Viraj Patel, strategist at Vanda Research in London, the global bond market can probably withstand another BOJ policy tweak, but rising inflation in Japan increases the potential for an abrupt and disorderly exit from yield-curve control.

“The BOJ is on the verge of making the same ‘transitory inflation’ policy mistake that the Federal Reserve made 12 months ago,” he said. “We’re positioning for Japanese policy normalisation to occur sooner, rather than later – and there’s a non-trivial chance it happens before the much-touted April BOJ meeting.”