Global bond investors are casting a nervous eye at Japan.
As a wave of selling washed across debt markets last week, the disclosure that the Bank of Japan had trimmed the volume of longer bonds it purchased was seized upon as the trigger for a move higher in yields that prompted veteran investor Bill Gross to again call the end of the three-decade bull run for the $14tn US Treasury market.
The intense interest in a standard operation in the BOJ’s quantitative easing programme revealed how sensitive investors are to any perceived changes at a juncture when the European Central Bank is halving its monthly bond buying and the Federal Reserve is tightening policy. The yield on the 10-year Treasury note came within touching distance of 2.63 per cent, its highest since Donald Trump’s election.
Bret Barker, a portfolio manager with asset manager TCW, says the blowback into the US Treasury market reflects how central bank easing through the BoJ targeting a zero yield for the 10-year Japanese government bond, as well as debt purchases and negative rates from the ECB, has acted as an anchor for global interest rates.
’If those anchors are released . . . that should increase volatility and raise longer rates in the US,” he says.
The BoJ’s policies have also prompted Japanese investors to escape the meagre returns on domestic bonds by hunting for higher fixed-rate returns in markets such as Europe and the US. Japanese investors held ¥291.8tn in foreign bonds as of September 2017, preliminary estimates show. Japan and China both have official Treasury holdings of more than $1tn.
Investors’ reaction to the disclosure about the BoJ’s most recent buying was likely amplified given Haruhiko Kuroda, the BoJ’s governor, surprised some with comments at the end of 2017 about the adverse economic effects of low interest rates. The temptation, then, for investors was to piece together a narrative that the BoJ would be the next to scale back its stimulus plan.
That is completely mistaken, say BoJ officials. Since September 2016, they say, the basis for BoJ policy is to keep 10-year bond yields on Japanese government bonds at “around zero per cent”. It now simply buys as many bonds as necessary to keep yields at the target. As the BoJ’s share of the total bond market gets bigger and bigger, it does not need to purchase as much to keep yields at the right level.
Since Mr Kuroda become the governor of the BoJ in April 2013, the central bank’s government bond holdings have ballooned to ¥442tn, which is more than 40 per cent of outstanding government debt. The BoJ has also accumulated ¥17tn in exchange traded funds, making it one of the largest equity investors in Japan.
Economists widely expect the BoJ to keep slowing the pace of asset purchases during 2018. They are split, however, on whether it will make a substantive change to monetary policy. Optimists on the economic outlook think the BoJ will let yields rise somewhat in the second half of the year.
However, investors should also be mindful of the BoJ’s innate caution, particularly regarding the currency. It would be suicidal for the central bank to say anything that strengthens the yen, says Yunosuke Ikeda, a strategist at Nomura. Only if certain conditions are met, such as 10-year Treasuries going over 2.70 and the yen at 120, can the BoJ start communicating about how to normalise policy, he adds.
Probably the most boring major currency of 2017, the yen has appreciated beyond ¥111 for the first time in seven weeks, taking its advance against the dollar this year to 1.5 per cent. That is not an earth-shattering gain — but it is the reason for the rise, not the size, that matters.
“It’s telling us where the market wants to go,” Alessio de Longis, portfolio manager at Oppenheimer Funds, says of the strengthening yen.
For investors, higher inflation and expectations of rising prices on the part of Japanese companies and consumers will be taken as a cue for a change in policy from the BoJ. But so far, there is little sign of it.
As Mr Kuroda said in a recent speech, there is still “a long way to go” to achieve its 2 per cent inflation target. The BoJ will continue to pursue what he calls “powerful monetary easing”.
Fixating only on BoJ policy, however, may be missing the point regarding the yen. An environment of rising Treasury yields, strong risk appetite and a favourable carry trade should be negative for the currency. But the resilience of the yen illustrates the changing nature of capital flows, Mr de Longis says. Foreign investors have been underweight the Japanese equity market for decades, he claims, but this is changing.
“The economy is doing better, the deflation drag is receding, corporate governance is improving and Japan has a very strong capital account surplus,” he says. Equity flows into Japan could be “one of those ingredients that has been missing for a very long time”.
As last week recedes, the reaction in the bond and currency markets has fizzled. “We think it would be a mistake to view it as hinting early normalisation in policy ahead,” says Takeshi Yamaguchi, an economist at Morgan Stanley MUFG.
Still the excitement illustrates the underlying nervousness of investors, and the immense communication challenge the BoJ will face when it does decide to head for the exit.
Additional reporting by Eric Platt