In the last days of 2017, we showed something surprising: as a result of suddenly exploding USDJPY funding costs, there had never been a worse time for Japanese investors, traditionally some of the most ravenous purchasers of US paper, to buy US Treasurys.
As we explained on December 27, USD funding costs for Japanese insurers and banks to invest in US Treasuries - which had surged reaching a post-financial-crisis high of 2.35% on 15 Dec - are determined by three things, namely (1) the difference in US and Japanese risk-free rates (OIS), (2) the difference in US and Japanese interbank risk premiums (Libor-OIS), and (3) basis swaps, which illustrate the imbalance in currency-hedged US and Japanese investments.
In this particular case, widening of (1) as a result of Fed rate hikes and tightening of dollar funding conditions inside the US (2) and outside the US (3) have occurred simultaneously. This is shown in the chart below.
Whatever the cause behind these sharp funding shortages, one thing was clear - dollar funding costs (FX hedging costs) for both Japanese insurers, banks and other investors to buy US Treasuries were surging (with Japanese buyers and reached a post-financial-crisis high of 2.35% on 15 Dec. And in terms of practical implications for the treasury market this means that, all else equal, marginal demand for US paper is about to plunge for one simple reason: the FX-hedged yields on US Treasurys have plunged to (negative) levels never seen before (unless of course foreign investors buy US Treasurys unhedged).
To demonstrate this point, the chart below from Deutsche Bank shows the yields on currency-hedged US Treasuries from the perspective of Japanese investors. Annualized hedge costs had risen to 2.33% at the end of December, which means that investments in 10y US Treasuries would result in virtually no yield. Furthermore, yields from investment in shorter than 10y US Treasuries would be less than JGBs and result in negative spreads.
And while TSY funding costs, and various X-CCY basis swaps in the past two weeks has dropped, Japan's lack of appetite for US Treasurys will only continue to rise.
The reason is that as the Nikkei reports, Japanese investors - traditionally the most enthusiastic foreign buyers of US Treasurys - have become far less enthusiastic about buying US debt last year on growing concern about rising U.S. Treasury yields. According to Ministry of Finance data released on Friday, Japanese investors' net purchases of mid- to long-term foreign bonds tumbled 94.6% on the year to 1.1 trillion yen ($9.9 billion) in 2017, the first annual decline in four years.
In prior years, Japanese institutional investors such as banks and life insurance companies had actively pursued foreign bonds in search of higher returns, finding few alternatives in Japan, where interest rates remained extremely low, and Europe providing few options as a result of the ECB's NIRP policies. As a result, the only option for many was US paper.
But the November 2016 election of Donald Trump as U.S. president sent the 10-year Treasury yield shooting up from around 1.8% to almost 2.6% in just over a month, and the yield stayed above 2% throughout 2017. Any investors holding onto Treasurys during the yield surge would have incurred significant losses as prices tumbled.
Life insurers' net purchases declined 8.4 trillion yen last year, and banks collectively turned into net sellers, with their net sales reaching a record 7.6 trillion yen. Over 2015 and 2016, in contrast, they bought 20.6 trillion yen more than they sold.
In March 2017, Japan's Financial Services Agency announced stricter oversight on foreign bond investment by regional banks. The following month, net sales of mid- to long-term bonds by Japanese investors hit a monthly record of 4.2 trillion yen.
And, of course, as discussed at the top, the higher cost of buying the U.S. dollar is also at play. Life insurers often hedge against a strengthening yen via foreign exchange swaps when investing in foreign bonds. But hedges have become more expensive due to higher U.S. interest rates and other reasons. So the appeal of investing in U.S. bonds has faded overall, unless of course, Japanese investors bid up US paper unhedge, which however could backfire dangerously should FX volatility pick up, or if the dollar continues to devalue against most G-10 peers.
The bottom line: foreign, and certainly Japanese demand for US Treasurys appears to be sliding, whether due to rising yields and P&L losses, or blowing out funding costs, at the worst possible time: just as net supply of US Treasurys is set to double from $488BN in 2017...
... to $1,030BN in 2018, as Goldman calculated last Friday.
Which means that just one hiccup, and yields will soar. It also means that we are one not so major bond tantrum away from the Fed begging preparations for the next massive bond monetization episode, also known as QE4.