Why the 30-year Japanese government bond yield could be the most important ‘risk indicator’ in the world now
NO, I’M not talking about the way I eat ramen. Rather, I’m referring to the (metaphoric) sound that could be made by an estimated US$4.4 trillion held by Japanese investors in global stocks, bonds and funds as they are either reduced, sold down or liquidated – and the proceeds transferred back to Tokyo.
Why? Because of a recent phenomenon. Many of Japan’s longer-dated government bond yields have recently spiked and are now at – or close to – record highs. This has created a rare moment of flexibility for Japanese investors who now enjoy the luxury of choice: invest domestically or abroad – without surrendering yield.
Consider the following. A Japanese investor in 30-year US Treasuries receives a yield of 4.7 per cent, which falls to a nugatory 1 per cent once 3.7 per cent USD/JPY hedging costs are factored in. Conversely, the 30-year Japanese government bond (JGB) yield is currently 3.2 per cent, thereby offering a 2.2 per cent unhedged, risk-free relative return – with the added benefit of home bias.
The global unwind has not happened yet. But with an estimated US$1.1 trillion alone held in US Treasuries, the fear among investors and policymakers is that if yields on Japan’s long-dated bonds continue to rise, the growing allure of such positive relative return could lead to a significant – and profoundly disruptive – repatriation of capital.
This, in my view, makes the 30-year JGB yield the most important “risk indicator” in the world right now.
Land of the rising yield
The relentless rise in Japan’s long-end yields is less about the recent – and transitory – rise in inflation, and more about the structural dynamics of monetary policy. Importantly, the Bank of Japan’s (BOJ) decision in 2023 to abandon yield curve control – a policy that suppressed long-term rates – and its partial shift towards ongoing quantitative tightening represent significant “yield drivers”.
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By shrinking its balance sheet, the BOJ is no longer the aggressive buyer of government debt it once was. Additionally, Japanese life insurers and pension funds, traditionally price-insensitive buyers of JGBs, are scaling back due to regulatory changes and demographic pressures. For instance, life insurers are projected to actually reduce JGB allocations as they prioritise liquidity to meet the needs of an ageing population.
Simultaneously, the reduction in demand coincides with Japan’s surging debt and fiscal challenges. With a debt-to-gross domestic product ratio of around 240 per cent – the highest among G7 nations – Japan also faces a fiscal deficit equivalent to 2.9 per cent of GDP in 2025, driven by rising defence spending, healthcare costs for its elderly population and climate-related expenditures.
Inevitably, burgeoning supply and diminishing demand for debt – coupled with ongoing political instability – lead to higher term premiums.
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Jolly good buys
To the extent the rise in yield is a relatively recent phenomenon, the allure of JGBs lies in their new-found competitiveness. Literally for decades, Japanese institutions – pension funds, insurers and banks – sought higher yields abroad, thereby accumulating the aforementioned US$4.4 trillion in foreign assets.
But yield differentials mean the economics are tilting away from US dollar-denominated investments, particularly because costly foreign exchange hedges to mitigate yen volatility can significantly erode returns. Thus, domestic bonds have become a compelling alternative, and could be even more so in the months and quarters ahead, should repatriated buying start depressing bond yields and pushing up prices.
If Japanese institutions were to redirect even a modest portion of their overseas assets to JGBs, the consequences of selling offshore and buying onshore risk could be profound. That said, amid delicate bilateral trade negotiations, I’m not sure the US administration would take kindly to the dumping of US Treasuries by Japanese investors; so, it may be that initial reinvestment strategies target European government assets.
Repatriated capital would likely bolster demand for JGBs, strengthen the yen and benefit Japanese equities; as almost certainly, a portion of such liquidity would find its way into the country’s risk markets.
On the flip side, reallocation would also reduce liquidity in global markets, particularly as the infamous yen carry trade unwinds. Space constraints preclude the proper examination of a “yen unwind”, but suffice to say that even the partial reallocation of assets needs to be handled with the utmost care.
How to play?
It should come as no surprise that, at Lombard Odier, we recommend a market-weight allocation to developed market equities, albeit with a preference for Japan. A better-than-expected trade deal has pushed Japanese equities higher, but we see further upside as foreigners return to gain exposure to a cyclical earnings-per-share upturn, and to a market where quality is improving consistently amid ongoing reforms.
In our view, the long-term outlook for Japan remains positive, as the structural improvement in corporate profitability and protection for minority shareholders encourage foreign capital to return, after years of shunning the market.
We continue to see signs of better capital allocation, in the form of non-core asset disposal, returning excess cash to shareholders via dividends and buyback, and unwinding cross-shareholdings. Managers who are not delivering are being ousted – another sign that the stick-and-carrot approach is starting to work.
As of right now, the “great sucking sound” remains a risk, but the implications for financial markets are significant. If it gains traction, Japanese assets could benefit as a rising tide of liquidity pushes asset prices higher. Outside Japan, the consequences would be mixed, with tightened global liquidity likely to impact those markets priced for perfection or with valuations stretched.
The writer is chief investment officer, Asia, at Lombard Odier
