Any respite for Japan’s bonds is likely to be short-term

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The writer is the Apac developed markets rates strategist at Société Générale

The attention of global investors is turning more to Japanese bond markets for good reason. The fragile supply-demand imbalance for longer-dated bonds in Japan has been broken by a slowdown in domestic investor demand with 30-year yields briefly touching record highs in late May.

With yields becoming more attractive, there’s been a return of the narrative that Japanese investors could start to repatriate funds from overseas. This theme is never far from the surface given Japan has the second-largest net external assets of any country at ¥533tn ($3.7tn) as of the end of 2024, according to Japan’s Ministry of Finance.

The consequences could be material. If capital from overseas investments gets sucked back home, this may damp demand for international assets. Given the total size of the portfolio investments, even single-digit percentage changes could see hundreds of billions of capital flows. Trying to predict when these actual flows will take place is nigh on impossible. The size of the net position means that changing portfolio allocations is likely to be slow. Rather than guessing when, we think it’s better to follow the money. Japan’s MoF offers high-frequency weekly flow data, which should be where the first waves from any change of investment geography will show up.

What does the data show? The opposite of repatriation. Since the start of March, the yen has gained about 4 per cent versus the dollar. Japanese investors have responded to the strong yen by more buying foreign assets, purchasing a net ¥7.5 trillion equivalent over this period, according to the MoF data. This includes the largest two weeks of foreign bonds on record. Given the size of the flows, it is reasonable to assume this has slowed down and even helped reverse some of the recent yen gains.

This is not a unique reaction, either. From July to mid-September 2024, after the Bank of Japan raised interest rates to 0.25 per cent and US jobs data unexpectedly cooled, the yen gained about 15 per cent against the dollar. This rally was helped at the time by bad positioning, with short positions of leverage funds betting on a fall in the yen at the highest in seven years.

Again, Japanese investors used currency strength to go on an all-out buying spree of foreign assets, purchasing a combined ¥10.9tn of overseas assets, according to MoF data. The slower-moving balance of payments data later offered more detail, showing Japanese funds bought ¥6.7tn in US sovereign and government backed paper during July and August, with the latter being the largest single monthly flow on record.

But clearly there is a bond market problem more generally across the world that needs to be fixed. Bond supply needs to be reshaped better to match demand as markets deal with transition from what former Federal Reserve governor Ben Bernanke dubbed the “global savings glut” to what European Central Bank governor Isabel Schnabel has called the “global bond glut”.

This shift comes from substantial government borrowing needs and a rise in the supply of “safe assets” as central banks unwind quantitative easing programmes of bond buying to support economies. Add to this higher volatility and elevated risk from changes to trade and government policy and it is obvious that investors will want compensation for taking on the risk of buying longer-term debt.

In Japan, the BoJ’s ownership of the government bond market sits at 52 per cent. As it runs down its balance sheet, private investors need to pick-up the slack. Life insurers (17.5 per cent), banks (12.7 per cent), pension funds (8.9 per cent) and foreigners (6.4 per cent) make up the next largest holders, according to data from the BoJ. But some insurers have already signalled their intention to reduce super long bond ownership over time. National and regional banks also have already rebalanced their yen bond portfolios lengths, in a move to limit interest rate risk. And pension funds are largely sticking to their existing allocation splits on asset classes. This has meant foreigners have been the only major buyers of long bonds recently, according to the flow breakdowns in the JSDA data.

The MoF is set to take a first step to address the issue. They have arranged to meet dealers on June 20, and are likely to make the rare move of changing bond sales in response to factors other than a new budget. It is likely to reduce long-term bond sales in favour of more short-term issuance. We suspect this can give some respite for long-dated bonds, but is unlikely to change the medium term theme.