In Just 48 Hours, Did Japanese Bonds on the Brink Push U.S. Bonds "Over the Cliff"?

Although the poor results of the 20-year government bond auctions held by Japan and the US within a short span of 48 hours were more isolated incidents—the panic in Japanese bonds stemmed from rumors of the Bank of Japan's tapering, while the sell-off in US bonds was more due to concerns over the loss of the AAA rating, uncontrolled deficits under Trump's tax cut bill, and the ballooning scale of bond issuance...

However, it may not be reasonable to argue that the market movements in Japan, the largest overseas "creditor" of the US, are completely unrelated to the fluctuations in US bonds.In fact, in the view of Deutsche Bank, amid the already weak demand for both US and Japanese bonds, there may currently be a fierce competition for chips between the two.

George Saravelos, Head of FX Research at Deutsche Bank, stated in a recent report released this week that US Treasuries are currently facing increasing competition from Japanese government bonds, with the rise in JGB yields making them more attractive to local Japanese buyers.

Saravelos has noticed a rather unusual phenomenon recently: the divergence between the trend of US bond yields and the yen exchange rate.—Even as US Treasury yields rise, the yen continues to strengthen in the foreign exchange market (the US dollar weakens against the yen).

As is well known, from the perspective of the carry trade logic in the foreign exchange market, the trend of US bond yields should typically be synchronized with the trend of the US dollar/yen exchange rate.

Saravelos currently views this unusual phenomenon as "the most important market indicator of the acceleration of US fiscal risks," as it suggests that cautious foreign investors are withdrawing funds from the US Treasury market.He pointed out, "We believe this is evidence of declining foreign investor participation in the US Treasury market."

Are Japanese bonds "sucking the blood" out of US bonds?

It is worth noting that the yields on long-term Japanese government bonds have also been climbing sharply recently. The 30-year JGB yield rose to its highest level since records began in 1999 this week. The demand for the 20-year JGB auction held on Tuesday was the weakest in decades.

Some market participants interpret this as a signal of increasing fiscal concerns in Japan, but Saravelos does not agree with this view.

Saravelos believes that if there were indeed fiscal risks, the yen should weaken rather than strengthen.As Saravelos pointed out in Deutsche Bank's global macro framework released last week, given Japan's positive net foreign asset position, its fiscal space remains ample.

This FX research head believes that the sell-off in Japanese government bonds poses an even greater threat to the US Treasury market: as domestic assets become more attractive to Japanese investors, this will accelerate capital outflows from the US market.

"The core logic of our view for the coming months is that the market is increasingly driven by external asset positions, a trend that is exerting dual downward pressure on the US Treasury market and the US dollar."

The indicator measuring market concerns over the twin deficits can be reflected by the beta value (slope) of the relationship between the net international investment position (NIIP) and yield in the chart below. This essentially reflects the global market's pricing of fiscal deficits. Historical data shows that this indicator has remained within a stable range since the global financial crisis.

Deutsche Bank believes that current market risks are accelerating towards a steeper slope—that is,the widening interest rate differential between the US and the rest of the world, potentially reverting to the pre-2008 market structure. As shown in the chart below:

In fact, Japanese bond yields may have already risen to a level high enough to begin attracting overseas investors, including Vanguard and RBC BlueBay Asset Management, while many domestic Japanese institutions may also be accelerating the process of asset repatriation.

Japan is the largest overseas "creditor" of US Treasuries, with holdings reaching $1.13 trillion as of March. This is the result of years of ultra-loose monetary policy in Japan, which drove domestic investors to seek higher returns abroad. Now, with long-term Japanese government bond yields also surging to over 3%, the "yield premium" advantage of US Treasuries for Japanese capital is rapidly narrowing.

When "Mrs. Watanabe" investors find that the cost-performance of domestic assets is returning, coupled with the dual pressures of deteriorating liquidity and widening credit premiums in the US Treasury market, the wave of Japanese capital withdrawal could become the last straw that breaks the camel's back.