Weak Dollar Fallout

These Naked U.S. Treasury Buyers Are Packing Up for Good

And Europe's probably the hot new destination.
Andrew Harrer/Bloomberg

The bad times are back for U.S. bonds, and it's not just a matter of inflation fears combining with fiscal profligacy. There is a third source of pain from an outside source: Japan. 

Japanese holders of Treasuries are having a rough time, getting hit by a double whammy of rising yields and a persistently weak dollar. And it looks like from the recent flow of funds data they've had enough -- their 866 billion yen ($8 billion) of sales last week was the first net weekly sale this calendar year. Confirmation of the trend may come on Friday, when the Ministry of Finance publishes the latest data.  

Japan's financial year-end is March 31, and that's typically a time to reduce exposure and cut losing trades. That is piling on the trouble for Treasuries.

Seasons of Selling

Japanese investors often reduce their foreign-bond holdings before their March year-end and September half-year reporting periods.

Source: Japan Ministry of Finance, Bloomberg

The start of April typically involves a new round of buying, and with only ultra-low yields available in Japan there is still a strong temptation to look abroad for a half-decent return. While the most popular destination has traditionally been American debt, 2018 probably won't see much Japanese money return to the U.S. 

What's changed is the dollar. Japanese investors have tended not to hedge their Treasury holdings, because the cost of stripping out the currency risk of dollar exposure has risen along with the Federal Reserve's move into a hiking cycle. The rolling three-month cost of hedging a dollar asset back into yen has soared from a 25 basis point floor three years ago to over 220 basis points now. 

For yen-based investors that leaves the net currency-hedged return on U.S. 10-year notes at only 60 basis points. As the yield on 20-year Japanese government bonds is similar it is hardly worth the effort investing abroad -- unless you take the currency risk.

That worked fine for a while. But the recent weakness of the dollar has taken away all of the return on U.S. Treasuries, and now Japanese holders face outright losses. 

See Ya

A stronger yen versus the dollar makes it more expensive for Japanese investors to hold U.S. assets

Source: Bloomberg

In comparison, due to negative European Central Bank rates, a net currency-hedged return on 10-year French government bonds is about 1.2 percent, double that of staying at home in 20-year JGBs. So it is more compelling for Japanese investors to hold European bonds currency-hedged than dollar bonds either hedged or naked. 

Japan (Probably) Loves Paris in the Springtime

French bonds offer the best return among foreign high-quality liquid bond markets for Japanese investors

Source: Bloomberg

Return calculation: French 10-year bond yield - three-month Euribor + three-month yen Libor + (Yen basis swap-Euro basis swap)/100

Once the new financial year starts in April, Japanese buyers could well start piling in to European debt. U.S. bonds will probably get left out in the cold. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Marcus Ashworth in London at mashworth4@bloomberg.net

    To contact the editor responsible for this story:
    Jennifer Ryan at jryan13@bloomberg.net

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