Think Japan will continue to buy US debt: – Overestimated risk

“Could Japan, the largest foreign buyer of US debt, suddenly stop buying?” asks the Wall Street Journal.

At a time when the issuance of US debt has increased, foreign investors have gone from owning 43 per cent of US government bonds to only owning around 30 per cent in the last decade. At the same time, the Bank of Japan (BOJ) has hinted at interest rate increases starting next year, which could give Japanese owners a reason to turn their investments away from the US bond market.

But be safe: A Japanese withdrawal from US bonds appears to be an overestimated risk, writes the newspaper.

The world’s largest “carry trade”

Since the financial crisis, the Japanese central bank has pursued such an expansive interest rate policy that they have not had interest rate hikes since. The policy interest rate is per today at -0.1 percent.

The BOJ’s interest rate policy, which is almost three decades old, created what analysts like to call the world’s largest “carry trade”: Traders borrow the yen at virtually no cost, exchange it for the currencies of countries that pay higher interest rates, and buy assets there. US Treasuries, corporate bonds and loans are obvious targets, given their high yields and relative safety.

Many of the institutions that participate in this “carry trade”, including banks and some pension funds and insurance companies, avoid holding foreign currency and use derivatives to hedge against exchange rate risk.

What matters is thus not the difference between American and Japanese interest rates, but rather the gap in hedging costs.

Again a net buyer of international debt

Despite high unhedged US Treasuries, this carry trade has not been profitable since mid-2022, due to costly hedging operations associated with the inverted US yield curve. This has led to Japanese banks reducing their holdings of US bonds, from USD 840 billion two years ago to USD 550 billion at the turn of the year.

The latest figures from the Japanese Ministry of Finance, on the other hand, show a reversal of this selling trend, with Japan resuming its role as a net buyer of international debt.

This is because hedging costs have moderated somewhat since the summer and that government interest rates have risen in relation to American interest rates, the newspaper writes.

An overestimated risk

A large Japanese withdrawal from US bonds thus appears to be an overestimated risk. The underlying hedging practices of Japanese investors have created a cushion against changes in interest rate policy, and recent trends indicate that Japan’s appetite for US debt is far from abating. An additional factor is that any interest rate cuts in the US or the EU will and could discourage the Japanese central bank from raising interest rates.

This “resilience” provides a degree of reassurance about the stability of demand for US bonds, even at a time when the world’s financial landscape is constantly changing.