Negative Yields Seen Driving Japanese to Prefer Europe Over U.S.

  • Japan's 10-year yield dropped to record minus 0.035% this week
  • Dollar hedging costs soar as Libor gap at widest since 2009

Japanese investors face a surge in dollar-hedging costs that’s making European bonds more enticing than Treasuries as a haven from sub-zero domestic rates.

The yield on 10-year Treasury notes drops to 0.58 percent when fully hedged for swings in the dollar-yen exchange rate, instead of 1.68 percent, based on Bloomberg calculations using currency forwards. Equivalent French sovereign debt yields 0.52 percent instead of 0.60 percent when protecting against euro-yen fluctuations, while Italian notes yield 1.63 percent instead of 1.71 percent. Buying 10-year Japanese government bonds offered a record-low of minus 0.035 percent on Wednesday.

Dollar hedging costs have soared for Japanese investors as the gap between the London interbank offered rates for yen and dollars widened to 60 basis points this week, the most since March 2009, driven first by anticipation of the first Federal Reserve rate increase in almost a decade, and then by the Bank of Japan’s decision to implement negative rates. Speculation has grown the European Central Bank will expand easing next month. All that adds up to a shift in costs that threatens to reverse a trend that saw investors from the world’s third-biggest economy buy a record 13.85 trillion yen ($123 billion) of long-term Treasuries over the course of 2015.

“With Japanese yields falling this far, domestic investors will have trouble returning to JGBs, so there’ll be a stronger incentive to buy foreign bonds,” said Yusuke Ikawa, a Tokyo-based strategist at UBS Group AG. “Dollar hedging costs have really jumped, so investors have no choice but to shift to euro debt.”

French Bonds

Ikawa recommends French sovereign bonds based on the yield level and the stability of the market. A Bank of France report this week showed business confidence unexpectedly jumped in January in the latest sign that the country’s recovery is gaining strength. The nation’s debt has returned 2.9 percent this year, compared to 2.1 percent for JGBs, according to Bank of America Merrill Lynch indexes.

France’s yield curve remains relatively steep compared to Japan’s, where the yield premium offered by 10-year securities over two-year notes sank to as little as 12 basis points Tuesday. The equivalent spread in France is 104 basis points.

About two of every three JGBs offer sub-zero yields, after the BOJ’s negative rates pledge combined with haven demand driven by global market turmoil. Japan’s 10-year bond yield has dropped from 0.22 percent before the BOJ surprised markets with its decision on Jan. 29 to introduce a minus 0.1 percent rate on some of the reserves financial institutions park at the central bank.

JPMorgan Chase & Co. forecasts the BOJ will announce another round of monetary easing at its two-day policy meeting that starts March 14. The central bank’s new stimulus will include cutting the rate on some excess reserves to minus 0.5 percent, JPMorgan Chase estimates.

‘Shift to Europe’

Investors anticipate an expansion of easing by the ECB after President Mario Draghi last month stressed his determination to stoke inflation after earlier saying policy makers would reassess stimulus at their March meeting.

Meanwhile the Fed is gauging when it can next raise rates, following a liftoff in December. While the futures markets indicate only 11 percent odds of that happening this year, policy makers have indicated four bumps to the benchmark rate are possible.

“As Japan’s yield curve sinks further and further under water, it’s difficult for investors to buy JGBs at reasonable prices, which means they need to accelerate the pace of their portfolio re-balancing toward foreign bonds even more,” said Kenta Inoue, a senior foreign bond strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo. “Treasuries remain the standard, but if the Fed continues to raise rates in 2017, the rise in hedging costs will push investors to either shift to Europe or stop hedging altogether.”

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