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The financial world “seems upside down”, writes Michael Heise, chief economist at Allianz, in Wednesday’s FT, noting that the spectre of inflation haunts countless TV and radio debates while gold and other precious metals are the flavour of the moment – and yet, he notes (our emphasis):
… at the same time, yields on the main bond markets seem to be falling into an abyss, as if inflation had been nailed into its coffin for the foreseeable future. Yields on German government bonds have been flirting with all-time lows in early summer, and US long-term interest rates are still hovering at an exceptionally low level.
In Japan, where the world “inflation” is barely in the vocab, the markets are positively “screaming deflation” as FT Alphaville noted earlier, with the yield on 10-year Japanese government bonds reaching 0.995 per cent on Wednesday – the first dip below the key resistance level of 1 per cent since August 2003.
Indeed, notes Hiese:
Bond markets have not only been ignoring all talk about inflation, but they are also absorbing quite a massive increase in the supply of government bonds in recent quarters. The fact that increasing supply is not depressing prices and pushing up interest rates is reminiscent of the Japanese experience, where standard economic theories have not given good guidance for some years. An obvious difference between JGBs and the US Treasury or German Bund markets is that Japan actually experienced deflation for a number of years, which of course justifies low long-term bond yields.
Call it “justified” or a “seven-year itch” – back to the yields of 2003 – but there are some extreme trends taking hold in Japan. Take currency markets for example, where the yen has reached its strongest level against the dollar since 1995 in recent months, hitting Y85.52 on Wednesday. Some fixed-income analysts meanwhile are predicting that 10-year yields could fall to 0.95 per cent by September.
The yen’s strength against the dollar partly reflects concern about US economic growth, following weaker-than-expected data this week on consumer spending, home sales and factory orders.
Lex, musing on yen strength last month, noted:
First, the yield spread between US and Japanese two-year bonds "“ which has second-guessed the yen/dollar rate well for three years "“ remains near record lows. Second, portfolio money has been gushing into Japan. Net equity inflows for the first four months of this year, for example, were running at the fastest rate since 1996, according to Morgan Stanley. Third, investors panicking about the eurozone or US profligacy had to buy something when selling euros and dollars
The return of the yen carry trade to forex markets, notes the FT, would put further downward pressure on the dollar, which has fallen more than 2 per cent in just a week against a basket of key currencies — while at the same time, yields on two-year US Treasuries fell this week to a new record low of 0.5341 per cent.
In the view of Japanese finance minister, Yoshihiko Noda, the low yields reflect “trust in Japanese bonds and a flight to quality”, according to Bloomberg.
But like everything in Japan, there’s much more to it than that.
For one thing, corporate Japan, in surpisingly good shape and better able to tap bond and money markets, no longer has the need for bank lending that it once did. The yen’s strength has failed to dent Japanese exporters, who along with much of corporate Japan have just turned in a much better earnings season than expected.
Japan’s biggest banks, having been on a capital-raising spree in the past year amid concerns about forthcoming Basel III capital requirements, are sitting on piles of yen with nobody to lend it to. Essentially, in the words of one veteran Tokyo-based bank analyst, the banks – which account for the vast majority of JGB holdings – “have no choice, buy JGBs or, nothing”.
Indeed, as the FT noted in June, for domestic fixed-income managers, too, there is little opportunity for diversification.
But we can see some interesting parallels, not least with some US trends, highlighted by Stan Collender at Capital Gains and Games on Tuesday in a post about how the “bond vigilantes” of yesterday have transformed into today’s “deficit cheerleaders”. He notes:
Instead of demanding reductions in the deficit and government borrowing and threatening higher interest rates if those don't happen, today's vigilantes are unmistakably saying just the opposite. They want Washington to do more to stimulate the economy, and they welcome the deficit and debt it will take to do it.
Among what Collender calls “technical and non-fiscal policy-related” factors driving high demand for US Treasuries is how banks are parking some of their excess reserves in this market.
Volatility in US stocks has also pushed some investors to allocate more of their funds to cash and cash-equivalents like Treasuries, he notes. Another factor, he adds, is that “overseas demand for federal securities has been high because US bonds are still considered the safest haven….”
Sound familiar?
While there is little blatant “vigilantism” in the staid markets of Tokyo, one test of investor appetite – and priorities – in the JGB market will be Thursday’s auction of 40-year JGBs.
According to RuiXue Xu at RBS Securities Japan, a rally in super-long end JGBs has been accelerating since the strong 20-year JGB auction in late July. She notes:
Yields have broken through important resistances one after another. 20-year yields declined to 1.65%, 30-year yields reached 1.67% and 40-year yields dropped to the historical low of 1.73% as of today's close. Keeping these in mind, [Thursday's] 40-year auction will test whether investors will still be willing to buy the super long end given current relatively low yield levels. Considering the 40-year's small auction size and its cheapness vs both 30-year and 20-year, we expect domestic real money to continue participating in the auction and it will not be difficult for them to absorb the JPY300bn new supply.
Related links: China in record JGB buy – FT JGB update: Is Japan the next Greece? – FT Alphaville Japan equities: The midget is limbo-dancing – FT Alphaville Japan pension fund in record JGB sales – FT
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