JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?”

Takeaway: Our fundamental research & quantitative risk management signals are suggesting that global duration risk is rising at an accelerating rate.

SUMMARY BULLETS:

  • In recent weeks, both our fundamental research and quantitative risk management signals are suggesting that global duration risk is rising at an accelerating rate. Sure, it could be a massive head fake, but we certainly won’t be the ones holding the bag if we’re sitting here at EOY ’14 with G-7 bond yields +150-200bps higher than they are now. At a bare minimum, this is an increasingly probable scenario worth looking into.
  • As we’ve shown in previous research notes (HERE, HERE and HERE), a demonstrable backup in JGB rates could serve to apply selling pressure upon global sovereign debt securities, dragging up rates across various markets. Per the most recent Bank of America Merrill Lynch data, the spread between the nominal yields on G-7 notes and JGB yields narrowed to 61 basis points last week, the lowest since 1990!
  • While it’s not new news that investors have been increasingly shunning duration risk, we think it’s important to understand all of the moving pieces, rather than just relying on consensus expectations for what the Fed is going to do next. 

To recap those moving pieces:

  1. Domestic labor market improvement driven by a housing market recovery that itself is driven by a timely and marked acceleration in US births and household formation and a domestic consumption acceleration that is fueled by a commodity tax cut that is perpetuated by #StrongDollar are all reasons why we think Fed policy is poised for a major inflection over the intermediate term.
  2. A weakening yen that facilitates rising JGB yields that are more attractive on a relative basis should serve as an incremental drag on demand for US Treasuries stemming from Japan, which, as a country, currently represents 19.2% of total foreign demand for US Treasuries.
  3. Lastly, in a global currency war, manipulators simply need to buy less dollars to remain competitive if the USD continues to rally on trade-weighted basis (the Trade-Weighted US Dollar Index is already up +6% YTD). That ultimately equates to the central banks of commodity producing nations (many of which are EMEs) buying less US Treasuries, at the margins, in order to hold down their nominal exchange rates. The very recent blood-bath we’ve seen across the commodity currency spectrum is supportive of this view.

In today’s monetary policy announcement, the BOJ kept its “quantitative and qualitative monetary easing” program unchanged today, citing its view that previous measures would spur growth and lift consumer prices. The move (or lack thereof) was expected by consensus and came amid what policymakers termed "positive movements" in the Japanese economy. Central bank governor Haruhiko Kuroda downplayed the suggestions that the BOJ had lost control of the JGB market and said they would tweak the terms of its bond-buying program "as needed" to keep prices in check.

Net-net-net, the BOJ meeting was total non-event. In our opinion, the only important takeaway was that the BOJ plans to hold a meeting with financial institutions and institutional investors on MAY 29 to discuss recent market movements. Headlines are likely to follow – especially as it relates to the specter of rising interest rates and how the BOJ plans to facilitate that event. We’re guessing Japanese banks and pension funds – which have anywhere from 25% to 65% of their total assets parked in JGBs, depending on institution – would like an “orderly decline” of the JGB market as the Abenomics agenda progresses.

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 1

 

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 2

Perhaps the most important news of the day was the releasing of Japan’s APR trade data, which was very disappointing and highlighted some of Japan’s key macroeconomic issues that we’ve been detailing to investors for the past 12-18 months.

Export growth accelerated to +3.8% YoY from +1.1% prior vs. a Bloomberg consensus estimate of +5.4%. Import growth accelerated even more to  +9.4% YoY from +5.5% prior vs. a Bloomberg consensus estimate of +6.7%.

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 3

Thus far, the weakening yen has yet to prompt any structural shift in Japan’s BOP dynamics (these things take time), and that’s keeping Japan squarely in deficit territory with respect to its seasonally-adjusted trade balance, which narrowed slightly to -¥767.4B from -¥919.8B prior vs. a Bloomberg consensus estimate of -¥602.9B.

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 4

If the Japanese economy fails to make an import substitution adjustment prior to achieving any assumed structural increase in export competitiveness and fiscal retrenchment, we’re going to see more realized volatility in the JGB market as the current account dips squarely into deficit territory – which means Japan will be at the hostage of international creditors who’ll ultimately demand higher yields to compensate for the currency risk and Japan’s now-hawkish inflation outlook.

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 5

A backup across the JGB yield curve as a function of the aforementioned macroeconomic risks is amplified with Japanese domestic investors allocating financial assets to equities (currently 6.8% of the total), at the margins, in lieu of cash and bank deposits (currently 55.2% of the total, which are traditionally then intermediated into JGBs).

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 10

As it relates to Japan’s deteriorating BOP dynamics, the only saving grace we can think of is for Japanese bureaucrats to defy popular consensus by restarting the country’s nuclear reactors in a major way – an event rumored to be in the political works post the Upper House elections in MAR. Recall that Japan’s imports of mineral fuels increased to 34.1% of total imports in 2012 from 28.6% in 2010, which was the last full-year prior to the earthquake/tsunami. Adjusting for the impact of turning off the nuclear reactors, which subsequently increased Japan’s need to import incremental energy products, the 2012 current account balance would have been a positive 2.2% of GDP – double the reported 1.1%.

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 6

As we’ve shown in previous research notes (HERE, HERE and HERE), a demonstrable backup in JGB rates could serve to apply selling pressure upon global sovereign debt securities, dragging up rates across various markets. Per the most recent Bank of America Merrill Lynch data, the spread between the nominal yields on G-7 notes and JGB yields narrowed to 61 basis points last week, the lowest since 1990!

Even assuming that spread stays flat or that there is room for further compression given Japan’s bearish outlook for real interest rates, a material back-up in JGB yields over the next 12-18 months (akin to the 1994 and 2003 episodes) could be very hazardous indeed for bond investors around the world.

While it’s not new news that investors have been increasingly shunning duration risk, we think it’s important to understand all of the moving pieces, rather than just relying on consensus expectations for what the Fed is going to do next. To recap:

  1. Domestic labor market improvement driven by a housing market recovery that itself is driven by a timely and marked acceleration in US births and household formation and a domestic consumption acceleration that is fueled by a commodity tax cut that is perpetuated by #StrongDollar are all reasons why we think Fed policy is poised for a major inflection over the intermediate term.
  2. A weakening yen that facilitates rising JGB yields that are more attractive on a relative basis should serve as an incremental drag on demand for US Treasuries stemming from Japan, which, as a country, currently represents 19.2% of total foreign demand for US Treasuries.
  3. Lastly, in a global currency war, manipulators simply need to buy less dollars to remain competitive if the USD continues to rally on trade-weighted basis (the Trade-Weighted US Dollar Index is already up +6% YTD). That ultimately equates to the central banks of commodity producing nations (many of which are EMEs) buying less US Treasuries, at the margins, in order to hold down their nominal exchange rates. The very recent blood-bath we’ve seen across the commodity currency spectrum is supportive of this view. 

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 7

All told, the writing’s on the walls here, folks. In recent weeks, both our fundamental research and quantitative risk management signals are suggesting that global duration risk is rising at an accelerating rate. Sure, it could be a massive head fake, but we certainly won’t be the ones holding the bag if we’re sitting here at EOY ’14 with G-7 bond yields +150-200bps higher than they are now. At a bare minimum, this is an increasingly probable scenario worth looking into.

Darius Dale

Senior Analyst

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 8

 

JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?” - 9