Will Japan’s new interest rate trajectory change repo dynamics?

Key Takeaways

• BOJ’s interest-rate pivot lays basis for new investment dynamics
• Higher rates might accelerate foreign interest
• Questions arise about potential repatriation of Japanese funds

On the surface, the Bank of Japan’s raising of its overnight interest rate into positive territory for the first time in 17 years might be good news for investors seeking better returns from government bonds.

The decision sent ripples through the financial markets and marks a significant shift from Japan’s long-standing ultra-dovish monetary policy. It also raises questions about the impact on (and dangers of) fixed-income and interest-rate derivatives dynamics, investment flows in and out of Japan, and how Tokyo authorities will respond to potentially more volatility in the yen.

Before we answer those questions, let’s set the scene.

Japanese foreign bond spree

One US dollar today buys about 155 yen, compared to about 100 ten years ago.

Therefore, it is no surprise that cash-rich Japanese institutions from the export-led economy hedged currency risk and sought better returns in the US and European bond markets, where interest rates were higher.

And they have done that to such an extent that, according to a blog post by the Council of Foreign Relations early last year, by the end of 2022:

‘Total holdings of foreign bonds by “private” Japanese institutional investors—so excluding Japan’s $1 trillion reserve portfolio—reached $3 trillion at their peak.’

The FT said last year that Japan has long been the biggest foreign owner of US Treasuries (USTs). Japanese investors are also significant holders of eurozone government bonds, particularly French ones.

Similarly, at home, the Bank of Japan’s defense of its ultra-low interest rate policy over the past few years has seen it aggressively buy Japanese government bonds (JCBs). Indeed, according to Statista, the BOJ’s ownership of the JCB market stood at almost 54% at the end of December 2023, which has affected the proper functioning of the market and liquidity.

Foreign interest in Japanese collateral

Japan has long distinguished itself from most other Asian markets as a safe haven, a high-quality investment bet and a useful diversification in portfolios. The country’s JGB market was stable, and could generate better returns in times of market turmoil when taking into account currency and inflation differentials.

Rising rates in Japan make investing in the country more interesting and attractive to foreign investors, from Europe, the US and elsewhere in Asia.

This also applies to repo and collateral generally.

According to a recent ICMA/ASIFMA survey, although repo in APAC still has a relatively small share of the global market, it is showing signs of maturity. European repo markets are net borrowers of APAC-issued collateral, especially JGBs. Additionally, the volume between counterparties based in the region is rising.

More broadly, as regulators around the globe tighten requirements regarding the quality of collateral types to reduce systemic risks, government bonds have come to the fore in internal asset liability management—and JGBs are at the front.

A November Nikkei Asia report said that, for the first time, international investors held a larger share (14.5%) of JGBs than Japanese banks did (13.1%), lured by the country’s low cost of borrowing. Go back 15 years, and Japanese banks cornered almost half the market.

Japan’s low interest rates for the past two decades and weak yen have driven demand for JGBs combined with currency hedges.

Land of the rising risk?

The BOJ’s recent raising of its overnight interest rate has significant implications for the yen, volatility and fixed-income dynamics. How the central bank responds to volatility will be crucial.

There are several risks for fixed-income investors:

• Higher interest rates could attract more investment into Japan, strengthening the currency, but they could also negatively impact economic growth and further weaken the yen.
• Japan has avoided the inflationary pressures (and interest rate spikes) that the US and Europe have endured, but if prices (and interest rates) were to rise quickly, bond yields could widen, and the yen could become more volatile.
• Interest rates rising could lead to significant mark-to-market losses for bond investments.

Repatriation: nothing new, and a trickle more than a stampede

One of the biggest fears commentators have mentioned in the wake of the BOJ’s change of trajectory in its yield curve control (which has suppressed interest rates and the derivatives market) is the potential repatriation of hundreds of billions of dollars of investments held by Japanese institutional investors in USTs and European government bonds.

The potential global repercussions of an exodus are serious as it would lead to lower demand for USTs, sending yields higher and making borrowing in the US higher.

But a steady decline in Japanese securities’ holdings abroad is more likely than a stampede.

The Council on Foreign Relations blog post last year highlighted that capital markets had already adapted to a change in the fixed-income behavior of Japanese institutional investors. From being consistent buyers of foreign bonds, Japanese investors sold approximately $200 billion in 2022, with a preference to exit more liquid US government bonds over corporate bonds.

It anticipated a continued reduction in foreign bond holdings, as hedged investors let maturing bonds expire rather than reinvesting overseas, suggesting that the substantial inflow into global fixed income from Japanese institutions will continue to diminish.

With the Fed, BOE and ECB interest rate policies still in flux, the gap with the BOJ’s rate remains wide, and we can expect Japanese investors to continue hedging their (currency) bets for better returns abroad. Repatriations will likely be gradual and steady.