The BOJ Faces An Unexpected Problem: Record Demand For Japanese Bonds

Once upon a time, the most popular “widowmaker” trade was being short Japanese bonds as a result of prevailing conventional wisdom that there is no way Japan’s demographically doomed society and stagnant economy can sustain interest rates near zero. 

Not anymore. In fact, according to the latest data from Japan’s Ministry of Finance compiled by Bloomberg, the “widowmaker” trade has been flipped on its head, as global investors just can’t get enough of Japanese bonds and in the week ended Dec. 7, foreign investors bought a net 1.72 trillion yen (or $15.2BN) in Japanese bonds, the most on record (the data starts in January 2005) and a third straight week of purchases.

How is this possible: why would any investor choose to buy Japanese bonds which yield just around 0.05%, when one can easily purchase US 10Y Treasurys at a yield of roughly 2.90%? Simple: currency hedging, because as the chart below shows, when eliminating currency risk (i.e. FX hedging) for the 10Y US in either euros or yen, the yield on 10Y paper drops well into negative territory as a result of the sharp yield different on the short end.

Then there is the general risk-aversion sentiment prevailing on trade desks, and which makes for a very strong argument why global funds are buying JGBs, said Stephen Innes, head of Asia-Pacific trading at Oanda. “When markets are risk averse, haven assets like the Japanese yen do well, and that risk off has added some flavor for their bonds too.”

Ironically, this sudden burst in JGB appetite is also mucking up the Bank of Japan’s own plans to modestly steepen its own yield curve (but not too much): recall that earlier this year, the BOJ tweaked its yield-curve control policy to embrace a wider range for 10-year yields (from 0-0.1% to 0-0.2%). And yet after yields initially popped higher, they’ve since sunk back toward zero amid the global debt rally that has pushed tens of billions of government debt once again back into negative yielding territory.

And yet, the BOJ remains trapped, because as much as it would like to provide a kicker to Japan’s long-suffering banks which have had a flat Net Interest Margin curve for years, any move to taper purchases further could revive questions about policy makers seeking to exit from mega-stimulus mode, and not only result in turmoil for the bond market but spur an unwelcome appreciation in the yen.

Still, in the global tightening context, Kuroda’s central bank is the one central bank that isn’t currently looking at official quantitative tightening, even if the BOJ is clearly, if unofficially, tapering its bond purchases, and according to Bloomberg the world’s second-largest debt market has seen the central bank slow down the year-on-year increase in its bond holdings by an average 3.2% per month in 2018; at this pace, the stockpile would rise just 26 trillion yen ($230 billion) over 2019, the smallest increase since it began quantitative easing in April 2013.

None of the above is formal policy however: “the BOJ has also drawn a line in the sand in terms of allowing yields to leak higher — given they’ve doubled down on their bond buying, there’s relative stability in the market,” said Tano Pelosi, a portfolio manager at Antares Capital in Sydney. “In a world with a lot of uncertainty, that can be attractive to some global investors.”

And since on an FX-hedged basis one may as well buy JGBs over US Treasuries, foreigners have no qualms about buying Japanese paper, especially since the BOJ will keep its 10-year yields in a range around zero percent for the foreseeable future and beyond.

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