Worst Loss in Decades Has Japan Shunning U.S. Debt at Wrong Time

Bloomberg has a nice piece on Japan shunning US Treasury debt.

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.

Opposite Direction

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.

‘No Value’

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.

Bond Market Calm Is Threatened by Fed’s $1.75 Trillion MBS Shift

Will there be a seismic shift in bond and agency MBS volatility as The Fed gradually raises rates and starts to unwind their massive balance sheet?

(Bloomberg) -By Liz Capo McCormick, Matt Scully and Edward Bolingbroke- As far as bond buyers go, the Federal Reserve is pretty laid-back.

Even as the central bank amassed trillions of dollars of debt to prop up the economy following the financial crisis, it didn’t hedge its holdings or worry about gains and losses that might keep ordinary investors up at night. This extreme buy-and-hold stance has had an incredible calming effect on the bond market. Volatility has plummeted to lows rarely seen in recent memory.

But all that is now poised to change. With interest rates on the rise, analysts say the Fed could start shrinking its unprecedented $1.75 trillion position in mortgage-backed securities by year-end. That’s likely to leave more in the hands in private investors and result in increased hedging activity, a practice that has historically exacerbated swings in the Treasury market.

“You’ll inevitably see more volatility,” said David Ader, the chief macro strategist at Informa Financial Intelligence. In 2003, a surge in “convexity hedging” triggered widespread losses in Treasuries as benchmark yields soared 1.45 percentage points in two months. Nobody is predicting anything close to a repeat. After all, the biggest hedgers back then were government-sponsored entities like Fannie Mae and Freddie Mac, which now own just a fraction of what they did and aren’t coming back.

But at a time when beleaguered bond investors are grappling with higher rates and the potential consequences of the Trump administration’s spending plans, the prospect of more volatility adds yet another thing to their list of worries.

Negative Convexity

What exactly is convexity? At its most basic, it’s a measure of a bond’s relative sensitivity to changes in interest rates.

When a bond has positive convexity, that means its price rises more than it falls when yields move. When it’s negative, like mortgage debt, its price falls more. When rates rise, hedging against convexity grows as the expected life of mortgage debt increases. That happens when refinancing slows, and tends to leave holders more vulnerable to losses.

But by protecting against those potential losses (selling Treasuries or entering into swaps contracts are two ways), traders can end up making the bond market more turbulent. That’s already starting to happen.

On March 9, analysts say hedging activity was triggered when 10-year yields hit 2.55 percent and then 2.6 percent, which in turn, pushed yields to a three-month high of 2.628 percent March 14. They slipped to 2.50 percent at 8:30 a.m. New York time Monday.

Tighter monetary policy may accelerate hedging. The Fed lift its benchmark rate a quarter-percentage point last week and signaled two more hikes this year. A few firms like RBC Capital Markets say Fed officials will start paring back their MBS re- investments as soon as the fourth quarter. (Most predict the first or second quarter of 2018.)

New Urgency

“This is a story that will play out over the course of a couple years,” said Jason Callan, head of structured products at Columbia Threadneedle Investments, which oversees about $500 billion. “This won’t be a big bang type effect, yet there is certainly reticence in the marketplace as to when the Fed’s reinvestment announcement will happen and what it will look like.”

Minneapolis Fed President Neel Kashkari, the only official to vote against this month’s rate hike, added new urgency to the discussion when he said last week that he would prefer the central bank announce a plan that explains how and when it will begin to reduce its balance sheet before boosting rates again.

It’s not just hedging in the MBS market that could hit Treasuries. Insurers, which have been buying protection against lower yields for years, may now do the opposite, especially if the upswing in growth and inflation continues and share prices keep rising, said Dominic Konstam, Deutsche Bank AG’s global head of rates research.

“That switch can flip if there’s a real breakout of the secular-stagnation story,” he said.

Big Win

More volatility could make it harder for investors, but anypick-up in trading would be a big win for Wall Street.

Big banks, facing a profit squeeze in recent years, curtailed trading in mortgage-backed securities, and in some cases, completely exited the business. Trading desks may also see a boost as investors unwind positions they were forced into
when the Fed bought up the all MBS, according to Mark Tecotzky, co-chief investment officer of Ellington Residential.

“It will result in better profitability for banks,” said Brad Scott, head of trading at RBC Capital Markets in New York. Wall Street “will have more opportunities based on higher volatility, and there will be more participants that are likely
t  enter the market.”

You can see from the following chart that Fed purchases of assets primarily focused on agency MBS in 2009/2010. Then Fed purchases of agency MBS began picking up steam again in November 2012 (aka, QE3).

As The Fed gradually raises The Fed Funds Target Rate, and The Fed begins to unwind their balance sheet, we may see a further slowing of prepayment speeds on agency MBS.

Here is Minneapolis Fed President Neel Kashkari voting against the rest of the FOMC at the latest meeting.

And please, do not read from The Book of The Dead!.

Twisted! LIBOR 3M Hits Highest Level Since End Of The Great Recession (Treasury Curve Twisted Since 06/30/09)

The London Interbank Offered Rate (LIBOR) has now reached its highest level since the end of The Great Recession in June 2009. LIBOR is important since many contract are indexed to it.


I guess we can say the same thing about The Fed Funds Target Rate (UB) — it too is at its highest rate since June 2009 with only two rate increases.


How has the US Treasury yield curve shifted between June 30, 2009 and today? The 1 year Treasury yield is 44 basis points higher today while the 10 year Treasury yield is around 100 basis points lower. Essentially, the Treasury yield curve has been twisted since the end of The Great Recession.


This is a character from the PlayStation game Twisted Metal, NOT Fed Chair Janet Yellen. Yellen’s hair is white and shorter.


Roll Out The Barrel: Real Personal Spending Lowest Since September 2009 As Fed Rate Hike Probability Hits 82%

Today’s economic news feed should be of interest to the The Federal Reserve.

Core Personal Consumption Expenditures (sans food and energy) for January were +0.3% MoM and +1.7% YoY, below The Fed’s target inflation rate of +2.0%.


Of particular note is Real Personal Spending for January 2017. It fell -0.3% from December and is the lowest since September 2009, just after the end of The Great Recession in June 2009.


And Real Disposable Personal Income YoY has been dropping steadily since January 2015.


Inflation under 2% and declining Real Disposable Income YoY. Not pretty.

So, of course, the market is betting on The Fed RAISING rates at the March 15 FOMC meeting. In fact, the current implied probability of a rate hike in the range of 0.75-1% is 82%.


Yes, there is little doubt that the Fed Funds rate will be rising over time.


I guess it is time to Roll Out The Barrel and play the Beer Barrel polka!