Back in February, around the time Bloomberg caught up to what we had been discussing for the past year, namely the historic dumping of US Treasurys by offshore official investors (such as central banks and reserve managers, just as the selling had in fact reversed and foreigners had resumed buying once more) we noticed that it was not China but Japan that had emerged as one of the most aggressive sellers of Treasuries following material Mark-to-Market losses on existing TSY holdings, prompting the foremost ex-Fed shadow banking expert Zoltan Poszar to declare the selling “a deer in the headlights moment”.
Fast forward two months, when according to the latest update from Deutsche Bank, Japan’s revulsion to fixed income products has accelerateed, and the Pacific island was a net seller of foreign bonds again in the past week, divesting another $12bn worth of securities. It was not only the third straight week of selling out of Japan, according to MOF data, but more remarkably, the the year-to-date divestment of $66bn in foreign bonds YTD is the biggest since 2002, the first full year of such data is available.
What is prompting the sudden liquidation? According to Deustche, “profit-taking most likely explains Japan’s selling.”
Ten-year Treasury yields declined in April to a lower level than any previous month since the Trump election. In the process, yen cross-currency basis has tightened to levels not seen since January 2016. Japanese investors use the yen basis (or more precisely, their derivative FX forwards) to hedge the currency risk of their coupon flows from non-yen bonds. The basis tightens when there is a drop in demand to swap yen for dollar.
The next chart, which shows the distinctive inverse relationship between cumulative Japanese purchases of foreign bonds and the 3m yen basis, should be useful to anyone still confused by what has been the biggest driver behind the gradual drop and sudden recent spike in the USD-JPY currency basis: it all has to do with Japanese TSY demand, and hedging costs (which we pointed out had risen so high last August it made TSYs and JGBs look equally priced to Japanese investors).
However, it’s not just the Yen basis (and thus relative USD shortage) that is impacted by the Japanese appetite (or lack thereof) for US paper. As the Deutsche fixed income team writes, the lack of love shown by Japanese investors for Treasuries might also be responsible for low 3m Libor fixings and the collapse in Libor/FF spreads.
In US money markets where Japanese banks also raise dollars, the rates they’ve been paying on commercial paper and certificates of deposit have narrowed vis-a-vis the rates they pay on repos. CP and CD rates are of course used by banks as the main input for daily Libor submissions. Three of the 17 contributing banks to USD Libor are also Japanese. The narrowing of rates Japanese banks pay to borrow dollar using CP/CDs versus repos is further evidence that unsecured funding costs have dropped, which is reflected in the tightening in Libor-FF spreads.
That said, the recent revulsion toward fixed income products out of Japan will probably not last for two reasons.
First, as DB notes, April typically tends to be a month when Japanese investors sell foreign assets as they take profits at the start of the fiscal year. Seasonality would suggest that Japan becomes a buyer again in May, with especially strong appetite for foreign bonds in the July to September period. Consequently, we would look for Libor-FF spreads to find some support in the coming month, especially if Treasury yields become attractive again.
The second reason comes from BofA.
In a recent report, the bank’s FX and rates strategists published a piece summarizing the investment plans of nine Japanese life insurance companies for the first half of their fiscal year (which began April 1st). This is what BofA found:
Over the past few years in particular, insurers have been amassing foreign bonds, and particularly US Treasuries, but that fund flow will probably change if US rate hikes continue. Foreign bond investment is increasingly dependent on yields, FX, and FX hedge costs, and will probably become more fluid. In the United States, rate hikes are expected to continue, so the USD/JPY hedge cost cannot be expected to decline much. As par the plans announced, many will likely be less active in hedging foreign bond than last year. Investment in unhedged foreign bonds is expected to be heavily dependent on levels of FX relative to assumptions (see below), and it is more likely to increase. Domestic yields have sunk due to the BoJ’s negative interest rate policy, making fund management in JGBs difficult and prompting the major insurers to stop selling a number of yen-denominated life insurance products.
In other words, the story remains largely the same in that domestic yields are too low for buying JGBs, and life insurers remain without any other option but to buy foreign bonds (Figure 1). However in a key change foreign bond purchases are likely to take place increasingly on a currency unhedged basis (Figure 2), which has two major implications for both Treasurys and US corporate bonds.
First it reduces the need to reach for yield, which means less buying of BBBs and BBs and longer maturities; however it also means that Treasurys across the curve are suddenly far more attractive to Japanese buyers as investors will no longer need to offset up to 80 bps in hedging costs.
Second Japanese life insurance buying is likely to be less steady and more tactical, depending on interest rates and FX. This means more (less) buying when rates vol is low (high). The FX assumption is that the USD/JPY is in the range 100-125 and will increase toward fiscal year end. That means currently at 111 we are in the middle of the range, but since the dollar is expected to appreciate buying will take place here and increase should the dollar weaken, decrease should it strengthen.
This dynamic, together with recent technicals (recall earlier we showed that Treasury futures traders had just experienced the biggest short squeeze in history), mean that the reflation trade could be further jeopardized due to yet another feedback loop linking a weaker dollar (and thus USDJPY), with lower yields, which in turn leads to even more weakness in the USD, and so n. Ultimately, it will be up to the Fed to break this latest adverse feedback loop, although with the US economy growing at just 0.7% in Q1, it will take a significant leap of faith by Yellen and the “data dependent” Fed that US output will recover by Q2 when the Fed is expected to hike by another 25 bps.
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