Displaced JGB Investors

(written with my Tokyo-based colleague Masashi Murata)

What the Bank of Japan is doing is not unprecedented. Rather it is the pace of its asset purchases that is striking. It will do in two years what the Federal Reserve took five years in terms of balance sheet expansion. It will boost its monetary base by around $1.335 trillion by the end of next year. It will be purchasing about 70% of new JGB issuance. The Ministry of Finance issuance and BOJ intended purchases do not appear to align very well and this appears to be impacting the curve and secondary markets.

One of the most important issues for the capital markets is the response by the displaced investors. It is well appreciated that Japan’s debt is largely financed domestically. There are three key holders of JGBs banks (~41%), insurers (~22%) and pensions (12%). Households account for about 4% and foreign investors 8%.

This kind of quantitative easing, different from the targeting of interest rates, has been tried before in Japan—April 2001-March 2006. Banks increased their holdings of non-yen securities as a percentage of their portfolios (which include Uridashi bonds) by 1.4% and life insurers and pensions by 3.6%.

If this was repeated now, it could lead to the portfolio investment outflow of JPY45 trillion (~$450 bln). The market response in the days since the BOJ’s announcement seems to be largely in anticipation of such flows.  While it is a dynamic situation, and institutional investors may take some time to adjust their strategies, some diversification may have already taken place. 

That the BOJ was going to become more aggressive due to new leadership or a change in its mandate has been long telegraphed. The real unknown was when not if. In the past 18 months, institutional investors have increased their foreign asset weighting of their portfolios; banks by 1.5% and life insurers and pensions by 0.75%.

In some ways, the choice faced by the institutional investors reminds one of the rant by a Woody Allen character complaining about a restaurant: “The food was poor and the portions small”. Yields in the main core bond markets that have the liquidity and transparency Japanese investors prefer, are low—near record lows. And the quality has deteriorated. Low yields for weakening credits, does not strike one as an attractive bargain.

Household investors face the same dilemma. The yen can buy 25% less foreign bonds than it could a year ago. The kind of assets they may be tempted to buy have increased in price. Meanwhile, the Nikkei has exploded. For the first time in years, the domestic equity market is exciting, up around 50% since it became clear to many that Abe was going to become prime minister. 

The recent weekly MOF portfolio flow data illustrates our concern that the market may be exaggerating the what the displaced domestic JGB investor is doing.  The data released earlier today covers the week through last Friday.  Japanese investors sold JPY1.145 trillion of foreign bonds.  This is the most in a year.  It was the fourth consecutive week that Japanese investors sold foreign bonds.  During that span it sold JPY2.235 trillion.  Moreover, in the 14 weeks of data this year, Japanese investors have been buyers of foreign bonds only three times. 

What many observers do not seem to be giving sufficient due to is that the weaker yen may encourage profit-taking on the large stock of foreign investment that Japanese have already accumulated and the appeal of the local stock market.  

Meanwhile, foreign investors prodigious buyers of Japanese equities, buying another JPY869 bln in the latest week.  They have been buyers in 19 of the past 20 weeks and have bought JPY6.5 trillion over this period.  This overstates the portfolio inflows into Japan as foreign investors trimmed their JGB holdings, but have still bought a net JPY4.82 trillion of Japanese financial assets (excluding bills) over the past 20 weeks. 

What has often happened in the past is that the money coming into Japan from its current account surplus and foreign investment was not offset by Japanese demand for foreign assets, foreign direct investment and speculative flows.  When the private sector struggled to re-cycle the surplus, the Ministry of Finance often has felt compelled to authorize BOJ intervention to fill the breech.  The last time it intervened was in late October 2011, when it sold $100 bln worth of yen in a single day.   Appreciating the fluidity of the situation and that trade balance has swung into deficit (through the investment income surplus remains substantial), and that Japanese corporates appear to be stepping up their foreign direct investment, we are concerned that the recycling problem may once again surface.