Japan’s Waning Appetite for Treasurys Fuels Anxiety on Wall Street

The shift is another example of inflation and rising rates altering investors’ long-held assumptions. The Federal Reserve’s interest-rate increases have weakened the yen and made it costlier for Japanese investors to hedge against currency fluctuations when buying U.S. assets. As a result, instead of counting on Japanese investors’ demand for Treasurys, investors have become increasingly concerned about a potentially destabilizing shift in global capital flows. 

Japan’s appetite for U.S. bonds has long been important to the economy and financial markets. The world’s third-largest economy is the U.S. government’s largest foreign creditor according to Treasury Department data, holding Treasurys with a market value of about $1.2 trillion as of August. Private Japanese investors poured hundreds of billions of dollars into U.S. and other foreign bonds in recent years, seeking better returns than they could find at home.

That flow, however, has sputtered in recent months, and many analysts don’t expect it to return soon. “Going forward, it isn’t clear there is going to be any new buying from Japan,” said

Brad Setser,

a senior fellow at the Council on Foreign Relations and former adviser to the U.S. Trade Representative.

The decline in Japanese demand comes as the U.S. bond market is suffering one of its worst years in history, having been battered by persistent inflation and escalating expectations for how high the Fed will need to raise rates. As bond prices have fallen, Treasury yields have climbed to their highest level in more than a decade. That has made loans more costly and fueled a sharp selloff in stocks.

Most likely, Mr. Setser and others say, Japan’s pullback will continue to be felt on the margin, applying still more upward pressure on Treasury yields. Many of the same analysts, though, worry that it could turn more damaging. At some point, the thinking goes, Japan might not only stop buying Treasurys but also start selling them at a faster pace, adding extra stress to the market.

Investors have already shown signs of nervousness. On Sept. 22, the yield on the 10-year U.S. Treasury note logged its second largest jump of the year after Japan’s government said that it was buying yen with dollars from its foreign currency reserves for the first time since the 1990s.

Since then, the government has, to some degree, supported investors’ initial fears by releasing data suggesting that it dipped into its securities holdings to raise the dollars needed, rather than drawing from its bank deposits. That, analysts say, likely means that it has sold short-term Treasurys because selling longer-term bonds would cause more market disruption.

So far, the government likely hasn’t sold enough to have a major impact on bond prices. Still, investors worry that it will have to continue selling just to keep the yen stable around a three-decade low against the dollar. That has fed a fear that it could eventually turn to longer-term Treasurys if it runs low on shorter-term bonds.

One problem is that the weakness of the yen is being driven by a wide gap between U.S. and Japanese interest-rate policy that is almost certain to only get wider in the coming months.

While the Fed has tried to fight inflation by lifting short-term rates from near zero to almost 4%, the

Bank of Japan

has remained committed to keeping even 10-year Japanese government bond yields near zero. This reflects fundamental differences between the U.S. and Japanese economies, with inflation hovering around 8% in the U.S. and just 3% in Japan.

Even so, U.S. investors also worry about what would happen if the BOJ moves to raise interest rates in any way. For many, one unsettling aspect of the Japanese government’s intervention in the current market is that it showed Japanese authorities are uncomfortable with the yen’s weakness, which has contributed to major increases in the costs of imported food and fuel—household essentials. 

Bank of Japan Gov.

Haruhiko Kuroda

has repeatedly said that the central bank has no plans to change its policy. Nonetheless, some analysts on Wall Street say that a shift is still possible next year, particularly if inflation remains above the BOJ’s 2% target for longer than the central bank expects and the Fed keeps pressure on the yen by continuing to raise rates.

In that scenario, the concern is that institutional investors in Japan would step up their selling of Treasurys so that they could increase their holdings of domestic bonds.

Already, such investors have pulled back from the global bond market.

For years, they had scooped up U.S. bonds in particular not just because they offered higher yields than Japanese bonds but because yields on longer-term Treasurys were higher than those on shorter-term Treasurys. This allowed them to earn good returns by borrowing dollars at short-term rates and then buying longer-term bonds—a move that also acted as a hedge against currency fluctuations.

Now, the trade doesn’t work, because short-term U.S. rates have caught up with longer-term yields.

Overall, Japanese life insurers and pensions alone reduced their foreign bondholdings by nearly $40 billion from April through September, according to Japanese government data compiled by the research consultant Exante Data. That comes after they added roughly $500 billion since the start of 2016, when BOJ policies drove Japanese bond yields below zero.

Toshio Fujimura, Sumitomo Life Insurance Co.’s head of investment planning, said his firm would reduce holdings of foreign bonds hedged against currency fluctuations “by several hundred billion yen,” the equivalent of a few billion U.S. dollars, while increasing its domestic bondholdings.

Mitigating the impact on the market, firms can shrink their bondholdings by not buying new bonds when old ones mature, rather than just dumping Treasurys.

Selling bonds that have fallen in price is a more difficult decision because it means booking losses, analysts say. But it makes more sense the more that the Fed raises rates, increasing the cost of rolling over short-term borrowing contracts. And it becomes even more likely if yields rise on Japanese bonds.

Write to Sam Goldfarb at [email protected] and Megumi Fujikawa at [email protected]

The shift is another example of inflation and rising rates altering investors’ long-held assumptions. The Federal Reserve’s interest-rate increases have weakened the yen and made it costlier for Japanese investors to hedge against currency fluctuations when buying U.S. assets. As a result, instead of counting on Japanese investors’ demand for Treasurys, investors have become increasingly concerned about a potentially destabilizing shift in global capital flows. 

Japan’s appetite for U.S. bonds has long been important to the economy and financial markets. The world’s third-largest economy is the U.S. government’s largest foreign creditor according to Treasury Department data, holding Treasurys with a market value of about $1.2 trillion as of August. Private Japanese investors poured hundreds of billions of dollars into U.S. and other foreign bonds in recent years, seeking better returns than they could find at home.

That flow, however, has sputtered in recent months, and many analysts don’t expect it to return soon. “Going forward, it isn’t clear there is going to be any new buying from Japan,” said

Brad Setser,

a senior fellow at the Council on Foreign Relations and former adviser to the U.S. Trade Representative.

The decline in Japanese demand comes as the U.S. bond market is suffering one of its worst years in history, having been battered by persistent inflation and escalating expectations for how high the Fed will need to raise rates. As bond prices have fallen, Treasury yields have climbed to their highest level in more than a decade. That has made loans more costly and fueled a sharp selloff in stocks.

Most likely, Mr. Setser and others say, Japan’s pullback will continue to be felt on the margin, applying still more upward pressure on Treasury yields. Many of the same analysts, though, worry that it could turn more damaging. At some point, the thinking goes, Japan might not only stop buying Treasurys but also start selling them at a faster pace, adding extra stress to the market.

Investors have already shown signs of nervousness. On Sept. 22, the yield on the 10-year U.S. Treasury note logged its second largest jump of the year after Japan’s government said that it was buying yen with dollars from its foreign currency reserves for the first time since the 1990s.

Since then, the government has, to some degree, supported investors’ initial fears by releasing data suggesting that it dipped into its securities holdings to raise the dollars needed, rather than drawing from its bank deposits. That, analysts say, likely means that it has sold short-term Treasurys because selling longer-term bonds would cause more market disruption.

So far, the government likely hasn’t sold enough to have a major impact on bond prices. Still, investors worry that it will have to continue selling just to keep the yen stable around a three-decade low against the dollar. That has fed a fear that it could eventually turn to longer-term Treasurys if it runs low on shorter-term bonds.

One problem is that the weakness of the yen is being driven by a wide gap between U.S. and Japanese interest-rate policy that is almost certain to only get wider in the coming months.

While the Fed has tried to fight inflation by lifting short-term rates from near zero to almost 4%, the

Bank of Japan

has remained committed to keeping even 10-year Japanese government bond yields near zero. This reflects fundamental differences between the U.S. and Japanese economies, with inflation hovering around 8% in the U.S. and just 3% in Japan.

Even so, U.S. investors also worry about what would happen if the BOJ moves to raise interest rates in any way. For many, one unsettling aspect of the Japanese government’s intervention in the current market is that it showed Japanese authorities are uncomfortable with the yen’s weakness, which has contributed to major increases in the costs of imported food and fuel—household essentials. 

Bank of Japan Gov.

Haruhiko Kuroda

has repeatedly said that the central bank has no plans to change its policy. Nonetheless, some analysts on Wall Street say that a shift is still possible next year, particularly if inflation remains above the BOJ’s 2% target for longer than the central bank expects and the Fed keeps pressure on the yen by continuing to raise rates.

In that scenario, the concern is that institutional investors in Japan would step up their selling of Treasurys so that they could increase their holdings of domestic bonds.

Already, such investors have pulled back from the global bond market.

For years, they had scooped up U.S. bonds in particular not just because they offered higher yields than Japanese bonds but because yields on longer-term Treasurys were higher than those on shorter-term Treasurys. This allowed them to earn good returns by borrowing dollars at short-term rates and then buying longer-term bonds—a move that also acted as a hedge against currency fluctuations.

Now, the trade doesn’t work, because short-term U.S. rates have caught up with longer-term yields.

Overall, Japanese life insurers and pensions alone reduced their foreign bondholdings by nearly $40 billion from April through September, according to Japanese government data compiled by the research consultant Exante Data. That comes after they added roughly $500 billion since the start of 2016, when BOJ policies drove Japanese bond yields below zero.

Toshio Fujimura, Sumitomo Life Insurance Co.’s head of investment planning, said his firm would reduce holdings of foreign bonds hedged against currency fluctuations “by several hundred billion yen,” the equivalent of a few billion U.S. dollars, while increasing its domestic bondholdings.

Mitigating the impact on the market, firms can shrink their bondholdings by not buying new bonds when old ones mature, rather than just dumping Treasurys.

Selling bonds that have fallen in price is a more difficult decision because it means booking losses, analysts say. But it makes more sense the more that the Fed raises rates, increasing the cost of rolling over short-term borrowing contracts. And it becomes even more likely if yields rise on Japanese bonds.

Write to Sam Goldfarb at [email protected] and Megumi Fujikawa at [email protected]