The last time it was this cheap for Japanese investors to buy Treasuries and hedge away currency risk was two years ago, when they were piling in and pushing holdings to a record high.
How times have changed. These days, America’s biggest foreign creditor is unloading U.S. debt. And in a warning sign for the $13.9 trillion Treasuries market, Japan’s famously risk-averse money managers are giving little sense that an about-face is imminent, even as their new fiscal year is poised to bring a clean slate after a punishing stretch of losses.
The specter of Federal Reserve rate hikes and the potential for economy-boosting fiscal stimulus are keeping Japanese investors from seizing a buying opportunity that seemed inconceivable just six months ago, before President Trump’s election. And their reluctance, even as the cost of insuring against swings in the dollar is near the lowest since January 2015, raises doubts about the sustainability of the latest U.S. bond rally.
“U.S. Treasuries are quite attractive, but uncertainties around fiscal and monetary policies are just too high,” said Yusuke Ito, a bond manager in Tokyo at Asset Management One, which oversees about $443 billion. “I see this kind of hesitation from many clients.”
Japan holds $1.1 trillion of Treasuries, edging China as the biggest overseas owner. As a result, its money managers have enough clout to break the deadlock between bulls and bears that’s kept the world’s biggest bond market in a range for months.
Japanese were net sellers of U.S. sovereign debt for three straight months through January, the longest stretch since 2013. Since Trump’s election, they’ve sold 4.28 trillion yen ($38.5 billion), Japanese Finance Ministry data show. They continued to unload foreign debt for most of March, turning modest net buyers in the most recent week.
The trend of outflows comes just as the diving expense of hedging via cross-currency basis swaps is boosting the appeal of Treasuries.
The swaps have attracted greater attention from investors in Japan and Europe looking to escape paltry domestic yields. Last year, with demand for the greenback and U.S. debt soaring, the rocketing cost to protect against dollar fluctuations effectively turned 10-year U.S. yields negative. That same phenomenon proved a boon for those with dollars to lend, including Goldman Sachs Asset Management and Pacific Investment Management Co. They were able to turn a profit on Japanese obligations yielding next to nothing.
Yet since the start of December, the tables have turned in favor of Japanese investors as demand for dollars and Treasuries has dimmed. The basis spread on dollar-yen cross-currency swaps with a three-month horizon shrank to as little as 21 basis points last week, the narrowest since January 2015 and down from as much as 95 basis points in November. As it declines, it cheapens one leg of the hedging transaction for yen holders.
As a result, for Japanese investors, the currency-hedged yield on 10-year Treasuries is about 0.9 percent, or more than 0.8 percentage point above JGBs with the same maturity. That’s close to the biggest advantage in a year.
Tetsuo Ishihara, a U.S. macro strategist in New York in the fixed-income division of Mizuho Securities USA Inc., saw their reticence first-hand this month in Tokyo. He spoke with clients there, and said they’re still reeling from losses on both Treasury positions and hedges on the dollar. Bloomberg’s Treasuries index fell 3.8 percent in the fourth quarter, the most in data going back to the 1980s.
“It was a double whammy,” Ishihara said. “They had been making money on their hedges and that money was being redeployed into U.S. Treasuries. So it was a vicious cycle that unwound post-Trump.”
Lower hedging costs should draw them back into Treasuries, Ishihara said. But it may not be as soon as some expect. While Japanese have tended to buy foreign debt when their fiscal year begins, the majority he surveyed still expect yields to climb in coming months.
So do most Wall Street analysts. Ten-year yields, stuck since early December between about 2.3 percent and 2.64 percent, will probably climb to 2.9 percent by year-end, the median forecast in a Bloomberg survey shows. The notes yielded about 2.36 percent Monday.
It’s not just Japanese who are balking. Mark Dowding, co-head of investment-grade debt at BlueBay Asset Management in London, said his firm has maintained a bet on higher U.S. rates, even as yields held to a tight range in 2017.
Traders are fully pricing in three additional quarter-point Fed hikes through the end of 2018, futures data show. Dowding, on the other hand, expects policy makers to move seven times in that span.
“All the risks are on the upside, even if President Trump delivers just a bit of his agenda,” Dowding said. “If 10-year yields got close to 3 percent, that would be a good time to book profits on the trade. But frankly, until they do, there’s simply no value in Treasuries as an asset.”
Others are more optimistic that Treasuries will draw overseas cash.
Steve Kang at Citigroup Inc. said the range-bound market may reassure Japanese life insurers in particular that yields won’t spiral out of control. And with geopolitical risks flaring in Europe and Japanese yields effectively fixed, U.S. government debt still serves as the best hedge, he said.
“There’s probably demand that’s lurking,” said Kang, a U.S. rates strategist in New York. “But they were waiting until after the Fed rate hike and perhaps some stabilization of the new administration, especially after their fiscal year-end.”
He still doesn’t expect their buying to approach 2016 levels, given the sting of recent losses.
“They’re just trying to let their wounds heal,” Ishihara said. “I get the impression they lack confidence with what to do next after taking those losses.
“We expect them to come back sooner or later,” he said. “It’s just very hard to tell when.”
Both China and Japan have decreased their US Treasury holdings since 2014. So the “shunning” has been around for a few years.
Japan’s 10Y yield follows the US Treasury 10Y yield closely, albeit about 230 basis points lower.
And the Japanese sovereign curve remains negative at tenors (maturities) of less than 10 years.
While Japan may be shunning US Treasuries for the moment, do not be surprised if they unshun Treasuries in the near future.