Global Bond Bulls’ Biggest BOJ Fear Already Well Under Way

(Bloomberg) — Regardless of whoever sits in the Bank of Japan hot seat, the biggest worry of global bond investors — a wave of Japanese cash heading home — has already begun in earnest and looks unlikely to stop.

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The yen rose and local bond yields climbed on Friday’s surprise that economist Kazuo Ueda looks set to be picked as the next BOJ governor, sending bond traders scrambling to determine whether he is a hawk or a dove. But beyond the yield fireworks that any hawkish policy shift may well soon ignite, the steady selling of overseas bonds in favor of local alternatives by Japanese investors is already an established market fact.

Last year they offloaded a record $181 billion of foreign debt and poured ¥30.3 trillion ($231 billion) into the local government bond market, according to the latest Ministry of Finance and Japan Securities Dealers Association data. The reason why global investors need to worry if Ueda does indeed remove the BOJ’s cap on yields is that there’s still more than $2 trillion of overseas bonds left to potentially sell.

“Our forecast anticipates a sustained shift in Japanese portfolio flows this year from overseas to domestic debt,” wrote JPMorgan Chase & Co’s Benjamin Shatil in a recent note. “This shift, we believe, is being prompted in part by a view that sustained price and wage rises will inform further relaxation of yield-curve control policy and greater BOJ tolerance for domestic yield rises.”

Japanese investors were net sellers in around 70% of 20 major global fixed income markets through late 2022, according to Shatil, with the largest outflows in Europe and Australia.

The chance of higher Japanese yields causing a destabilizing spillover into global debt markets gained traction in December, when a modest tweak to the BOJ’s ceiling for the 10-year benchmark sent Treasuries lower and touched everything from US equity futures to the Australian dollar and gold. Japanese investors own more than $1 trillion of US Treasury securities and significant amounts of bonds from the Netherlands, France, Australia and the UK.

The concerns will have global bond investors keeping a watchful eye on Tuesday’s official nomination for Governor Haruhiko Kuroda’s replacement. But those worried that new management could be the catalyst for further Japanese outflows from overseas assets have reason to be fearful, regardless of whether Ueda turns out to be hawk or a dove.

New BOJ Chief’s First Task Will Be to Keep Speculators at Bay

Should Ueda shift policy and drive Japanese yields higher, their increased relative attraction is sure to tempt the country’s giant insurers and pension funds to accelerate a return of cash home. But even if he keeps policy changes to a minimum, that’s just likely to renew last year’s pressure on the yen and feed into its onerous hedging costs, another key catalyst for last year’s Japanese overseas bond outflows.

With those costs still sky high, even Japan’s artificially capped 10-year yield of 0.5% is more attractive to a local fund manager compared to the minus 1.3% yen-hedged yield they would get from equivalent Treasuries.

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“When they finally let rates go, domestic institutions in Japan who’ve been waiting and waiting for higher returns could pounce on JGBs,” said Amir Anvarzadeh, a strategist at Asymmetric Advisors in Singapore, who has tracked Japanese markets for three decades.

The heightened scrutiny over the investment plans of some of the world’s biggest fixed-income investors comes at a time when the global bond market is back under pressure. Yields have started to climb once more as expectations for peak US interest rates grind higher on robust employment data and fears inflation may not be quickly vanquished.

Bond Investors Brace for Risk of Inflation Fueling Bear Momentum

For Viraj Patel, strategist at Vanda Research in London, the global bond market can probably withstand another BOJ policy tweak, but rising inflation in Japan increases the potential for an abrupt and disorderly exit from yield-curve control.

“The BOJ is on the verge of making the same ‘transitory inflation’ policy mistake that the Federal Reserve made 12 months ago,” he said. “We’re positioning for Japanese policy normalization occurring sooner, rather than later – and there’s a non-trivial chance it happens before the much-touted April BOJ meeting.”