Japan as the Next QE

January 16th, 2014 8:58 am | by John Jansen |

I had a difficult time coming up with reasons for the market rally this morning until I read the David Ader piece from CRT Capital and he noted the cheapness of US bonds versus counterparts around the globe. I have since posted a piece on the precipitous plunge in peripheral bond yields and a subsequent conversation with a fully paid up subscriber led me to an FT story which posits that Japanese flows will replace the Fed as a source of buying power in the long end of the US. Ten year Japan versus US is at about 225 basis points. The trader with whom I spoke noted that in three decades it has never been wider than 250 basis points. The FT article says that 200 basis points is usually the trigger for the move. The FT writer suggests that core inflation in Japan is on top of 10 year yields where in the US there is still a reasonable spread between core inflation rate and 10 year bond yield . I believe using the CPI this morning it was over 100 basis points and it is probably alot wider versus the Fed’s favored metric PCE. In addition the Bank of Japan is actively debauching and debasing its currency and that will drive some to use where one can argue that the debasement is surreptitious.

Via the FT

Treasury market poised for jump in foreign inflows

By Michael Mackenzie in New York and Ben McLannahan in Tokyo

The consensus among strategists at the start of 2014 was that stocks would make further gains and bonds would lose ground, but already US Treasuries are putting that thinking to the test.

After a dismal 2013, long-dated US bonds have begun the new year on a tear. Their total return gain of 2.5 per cent for January was helped by a boost in the wake of last week’s disappointing employment report for December. So, are long-dated Treasury bonds a candidate for the comeback asset class in 2014?

The answer will depend in large part on what foreign investors, led by the Japanese, think. Foreign buyers have long been a crucial pillar of support for the Treasury market. And, as long-term US investors have sought bonds this month, some think it is only a matter of time before the rest of the world follows, led by Japan, where 10-year Japanese government bonds currently yield less than 0.7 per cent.

Ashish Shah, head of global credit at AllianceBernstein, says a swing factor for US assets this year is Japan and sees a likely acceleration in demand once the Japanese financial year ends in March.

“There is so much excess liquidity and the benchmark asset JGBs are no longer attractive as they yield less than headline inflation,” says Mr Shah. “We should see a rebalancing and we are already seeing investor interest out of Japan for [US] investments that provide nominal returns.”

Motivating domestic US buyers at the moment is the fact that long-term Treasury yields, which move inversely to prices, are far higher than they were a year ago. Moreover, the low level of US inflation boosts the appeal of owning long-dated bonds, particularly amid concern that US equities are fully valued and due a correction.

As the Federal Reserve looks to reduce slowly its emergency monthly purchases of $40bn in Treasury debt, the question facing the bond market is whether long-term yields already largely reflect the impact of the taper and are at levels that can draw other buyers as the central bank retreats from the market.

For bond strategists, higher US bond yields and the expectation that the yen weakens further against the dollar help offset worries about the Fed’s taper. “This is the trade for this year,” says John Brady, managing director at RJ O’Brien. “As the Fed steps back, Japanese investors will step in and buy long-dated Treasuries.”

The rationale for such a shift lies in the attraction of much higher real US yields over those in Japan. With core annual inflation running just above 1 per cent, investors could pick up a generous real yield from buying 10-year Treasury notes that pay a current coupon of 2.75 per cent.

By contrast, the 10-year Japanese government bond yield of 0.68 per cent sits just above that country’s so-called “core-core” inflation rate (excluding fresh food and energy) of 0.6 per cent, its highest level in 15 years.

But at what point will those widening yield differentials between US and Japanese benchmark bonds start to lure flows?

In the past, a 200 basis point spread between 10-year JGBs and US Treasuries has been an “important trigger” for pushing domestic investors into foreign bonds, says Satoshi Shimamura, head of rates and markets in the investment strategy department at MassMutual, which manages about Y1.6tn ($15.3bn) of assets in Japan.

That spread, now just over 220 bps, has averaged 215 bps since the beginning of November. While the arithmetic looks compelling, there is little sign yet of a big rotation: flows into foreign bonds from major Japanese investors have yet to establish a firmly positive trend.

Between July and November there were five straight months of net purchases of foreign bonds and notes, following five months of net sales. But December saw another Y499bn of net sales, according to provisional finance ministry data.

Over the first 11 months of the year, investors including commercial banks, insurers, fund managers and trust banks bought a net Y180bn of foreign bonds and notes, easily the smallest haul since the data series began in 2005.

One catalyst could be the performance of Japanese equities. The Nikkei 225 remains in negative territory this month after a huge rally of nearly 60 per cent last year. “The pivot will be the performance of the Nikkei and if we see stocks lose ground, that may force Japanese investors to look at US bonds,” says William O’Donnell, strategist at RBS Securities.

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  1. 4 Responses to “Japan as the Next QE”

  2. By Squints on Jan 16, 2014 | Reply

    John, whaddya mean the NEXT QE? 8^)

    Like Blink 182, how many times they gonna make that record?

  3. By John Jansen on Jan 16, 2014 | Reply

    Just that japanese buyers allegedly will replace the Fed as wide spread and tanking yen force them to leave home

  4. By Squints on Jan 16, 2014 | Reply

    I kid. Indulging my inner Austrian. Wouldn’t be following if I wasn’t valuing the color.

  5. By John Jansen on Jan 16, 2014 | Reply

    Inner Austrian. I like that very dry and very inside baaseball!!

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