Published December 17, 2013
So which seems like a better deal to you: A 10-year government security yielding 2.8% in a country where its central bank is likely to wind down monetary stimulus, or a 10-year government security where the yield is 0.65%, and the central bank’s printing presses show no signs of stopping, and in fact are only likely to increase?
In addition, the first security arguably has less credit risk, with net debt at just 87% of GDP as compared to 138% for the second country. Most investors would undoubtedly choose the former, as the advantages of the first bond do seem overwhelming relative to the second scenario.
Keep in mind that this is not a hypothetical situation, nor are these emerging market countries we are talking about. As I am sure many of you are aware, the first security is a US Government Treasury, while the second security is a 10-year Japanese Government Bond.
Now, Japanese securities have always yielded less than their US counterparts, and there are structural reasons for this discrepancy. Japanese banks are required to hold a certain amount of Japanese bonds for regulatory reasons, and many Japanese simply have a bias to purchase the securities of their own country. While the first of these reasons will remain unchanged, it is becoming more difficult for the Japanese investor to ignore the advantages of US government securities. This is particularly true in light of the recent weakness of the yen as a result of the Japanese Central Bank’s massive $1.4 trillion quantitative easing program, which will in essence double the country’s money supply, making the yen less valuable.
Japan already holds more US Treasuries than any other foreign entity besides China, holding roughly $1 trillion of US Treasury debt. However, after trimming its US holdings earlier in the year, Japanese demand has picked up and has helped prevent the 10-year Treasury from rising above 3% -- this despite the likelihood of the Fed’s much-anticipated taper of its quantitative easing program. Japan’s national debt, mostly held by the Japanese, is nearly $10 trillion. So, there is plenty of ability for Japanese investors to sell their country’s debt to fund purchases of more US Treasury Securities.
So what are the implications for US investors for the potentially large Japanese appetite for Treasuries? Well, there are both positives and negatives. While the Japanese cannot replace the Fed’s $85 billion a month in Treasury purchases, they could at least partially offset the coming taper. This could help long-term rates remain stubbornly low, which would in turn help the housing market and keep current market price earnings ratios at healthy levels. Taken in this light, the Japanese interest in US Treasuries is very healthy for the market.
However, keep in mind there are risks as well. The yen’s decline could accelerate if more Japanese investors begin placing their money abroad. This would make other nations’ currencies less competitive, and the recent rise of the euro against the yen could be a hindrance to Europe’s economic recovery.
In addition, if the yen slides too far as foreign assets are accumulated, it could be unsettling to the financial markets. With debt service at nearly 25% of national expenditures, Japan literally cannot afford to raise rates to support the yen, so the currency’s decline could be dramatic enough to pose risks to the global financial systems.
One of the big stories of 2013 has been the big boost to the global markets by easy monetary policy, and the Bank of Japan, along with the stimulative fiscal policy of “Abenomics” has been a big part of that policy. As we look for the big potential stories for 2014, Japan one again comes to the forefront. But if Japan’s citizen investors decide they will no longer tolerate very low yields with a declining currency, the results may not work out as favorably for the global markets.