Blame Japanese Banks for the Flat Treasury Curve, Citigroup Says

  • Theory of pension-fund buying at the long-end gains clout
  • Japan commercial lenders pare exposure amid hedging costs

Mount Fuji and buildings in the Shinjuku district are reflected on a table at an observation deck in Tokyo.

Photographer: Kiyoshi Ota/Bloomberg

The seemingly worrisome dynamic in the world’s largest bond market -- the flattening Treasury yield curve -- may have a relatively simple explanation: Japanese banks are selling short-dated U.S. debt.

A combined uptick in currency-hedging costs and paper losses on Treasuries with short maturities has likely spurred Japanese lenders to pare exposures in recent months, according to Citigroup Inc., citing shifts in dealer inventories and Ministry of Finance transaction data.

“We believe this combination of negative carry and poor performance may have triggered selling of original three-year to five-year holdings from Japanese banks,” Citi rate strategists led by Jabaz Mathai wrote in a note on Dec. 1.

The country’s commercial lenders typically use swaps to protect returns from foreign-exchange swings. Currency-adjusted carry from Treasuries with terms up to three years is now negative, according to Citigroup. And Japanese buyers are now nursing losses on FX-hedged U.S. bonds that they snapped up in 2015, as interest-rate markets since September have priced in a more hawkish Federal Reserve.

“The prospect of fiscal stimulus and associated hawkish Federal Reserve reaction, coupled with expectations of further widening of the cross-currency basis driven by normalization of the Fed’s balance sheet, could be yet another reason for banks to liquidate front-end UST positions,” the strategists conclude.

How the booming stock market is flattening the Treasury curve

Citigroup strategists join a chorus of Treasury voices who say technical factors are largely compressing the gap between short- and long-dated yields to a decade-low -- a source of solace to those fearful the curve may be flashing a warning sign for the U.S. economy.

On the flip side, this year’s equity windfall also may be spurring pension funds to raise long-dated fixed-income exposures to balance thresholds, according to a popular view on Wall Street.

Deutsche Bank AG strategists back-tested this theory using a model projecting pension allocation trends against equity performance. Their conclusion? Booming stock markets boost the funded status of public plans, spurring allocations to fixed-income, strategists at the German bank led by Dominic Konstam wrote in a note on Dec. 1.

That dynamic should drive $75 billion of additional bond purchases in the fourth quarter based on the present level of the S&P 500 Index. The number would rise to $135 billion if the gauge climbs to 3,000 from around 2,650, where it currently stands.

“We believe that the latest leg of curve flattening has been, to a large extent, driven by front-end selling from Japanese banks and back-end buying from domestic pension funds, and we expect these flows to continue into next year,” Citigroup strategists conclude.

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