A $3 trillion threat to global financial markets looms in Japan

(Bloomberg) — Bank of Japan Governor Haruhiko Kuroda changed the course of global markets when he unleashed a $3.4 trillion hose of Japanese money on the investment world. Now, Kazuo Ueda is likely to dismantle his legacy and set the stage for a trend reversal that could send shockwaves through the global economy.

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A little over a week before a significant leadership change at the BOJ, investors are bracing for the seemingly inevitable end to a decade of ultra-low interest rates that has punished domestic savers and sent a wall of money abroad. The exodus accelerated after Kuroda began depressing bond yields in 2016, culminating in a mountain of offshore investments that accounted for more than two-thirds of Japan’s economy.

All of this threatens to unravel under new Governor Ueda, who may have no choice but to end the world’s boldest experiment in easy money, while rising interest rates elsewhere are already shaking the international banking sector and threatening financial stability. The stakes are huge: Japanese investors are the largest foreign holders of US Treasuries, owning everything from Brazilian debt to European power plants to pools of risky state loans.

A rise in Japan’s borrowing costs threatens to exacerbate volatility in global bond markets, which have been rocked by the Federal Reserve’s years-long campaign to fight inflation and the new threat of a credit crunch. Against this backdrop, the BOJ’s tightening of monetary policy following the recent banking turmoil in the US and Europe is likely to intensify scrutiny of their country’s lenders.

A policy change in Japan is “an additional force that goes unappreciated,” and “all G-3 economies will, one way or another, reduce their balance sheets and tighten their policies,” said Jean Boivin, Japan’s head of the BlackRock Investment Institute and former Deputy Governor of the Bank of Canada. “When you control a price and loosen the grip, it can be challenging and messy. We think it’s a big deal what happens next.”

The flow reversal is already underway. Japanese investors sold a record amount of foreign debt last year as local yields rose on speculation that the BOJ would normalize policy.

Kuroda added fuel to the fire last December when he eased the central bank’s grip on yields by a fraction. In just a few hours, Japanese government bonds collapsed and the yen soared, rocking everything from Treasuries to the Australian dollar.

“You’ve already seen this money being repatriated to Japan,” said Jeffrey Atherton, portfolio manager at Man GLG, part of Man Group, the world’s largest publicly traded hedge fund. “It would be logical for them to bring the money home and not take the exchange rate risk,” said Atherton, who manages the Japan CoreAlpha Equity Fund, which has beaten about 94% of its peers over the past year.

Return home

Bets on a change in BOJ policy have faded in recent days as the upheaval in the banking sector raises the prospect that policymakers may prioritize financial stability. Investor scrutiny of Japanese lenders’ balance sheets has increased amid concerns they may reflect some of the strains that have crushed several US regional banks.

But market participants expect chatter about BoJ adjustments to resume as tensions ease.

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Ueda, the first-ever academic to lead the BOJ, is expected to accelerate the pace of policy tightening later this year. Part of this could include further easing the central bank’s control over yields and unwinding a gargantuan bond-buying program aimed at lowering borrowing costs and boosting Japan’s ailing economy.

The BOJ has bought 465 trillion yen ($3.55 trillion) worth of Japanese government bonds since Kuroda introduced quantitative easing a decade ago, according to central bank data, which has depressed yields and fueled unprecedented distortions in the government bond market. As a result, local funds sold 206 trillion yen worth of securities during the period to seek better returns elsewhere.

So massive was the shift that Japanese investors became the largest holders of government bonds outside the US, as well as owners of about 10% of Australia’s debt and Dutch bonds. They also own 8% of New Zealand’s securities and 7% of Brazil’s debt, according to Bloomberg calculations.

The reach extends to equities as well, with Japanese investors having invested 54.1 trillion yen in global equities since April 2013. Their stock holdings represent between 1% and 2% of stock markets in the US, Netherlands, Singapore, and the UK.

Japan’s ultra-low interest rates were a big reason the yen fell to a 32-year low last year, and it’s been a top option for profit-seeking carry traders to fund purchases of currencies ranging from the Brazilian real to the US$ Indonesian rupiah.

“It has almost certainly contributed to a significant decline in the yen and massive dysfunction in the Japanese bond market,” said Jim O’Neill, a former UK government minister and chief economist at Goldman Sachs Group Inc., of Kuroda’s policies. “Much of what happened in Kuroda’s time will be partially or fully reversed,” should his successor pursue policy normalization, although the banking crisis may prompt authorities to tread more cautiously, he added.

The currency has retreated from last year’s lows, helped by the view that normalization is inevitable.

Add last year’s historic global bond losses to that equation, and Japanese investors have even more reason to flock home, according to Akira Takei, a 36-year market veteran and money manager at Asset Management One Co.

“Japanese bond investors have had bad experiences outside the country over the past year because a significant jump in yields has forced them to cut their losses, so many of them don’t even want to see foreign bonds,” said Takei, whose Tokyo-based firm manages 460 Billion dollars. “They now think that not all funds have to be invested abroad, but can be invested locally.”

The new president of Dai-ichi Life Holdings Inc., one of Japan’s largest institutional investors, confirmed it was shifting more money from foreign securities to domestic bonds after aggressive US interest rate hikes made hedging against currency risk costly.

Certainly few are willing to put their faith in Ueda rocking the boat once he takes office.

A recent poll by Bloomberg found that 41% of BOJ watchers expect a tightening move in June, up from 26% in February, while former Japanese Deputy Finance Minister Eisuke Sakakibara said the BOJ could hike rates by October.

A summary of opinion from the BOJ’s March 9-10 meeting showed that the central bank remains cautious about conducting a policy shift before hitting its inflation target. This was even after Japan’s inflation accelerated to over 4% and hit a new four-decade high.

The next central bank meeting, the first of Ueda, is scheduled to take place on April 27-28.

Richard Clarida, who served as vice president of the Federal Reserve from 2018 to 2022, arguably has more insight than most, having known “straight shooter” Kuroda for years and weighing Japan’s influence on US and global monetary policy.

“Markets expect yield curve control to be phased out fairly early under Ueda,” said Clarida, now global economic adviser at Pacific Investment Management Co. “It’s not for day one,” he said, adding Japan’s tightening would be a “historic moment” for markets, although it may not be a “driver for global bonds”.

Gradual shift

Some other market watchers have more modest expectations of what will happen if the BOJ rolls back its stimulus plan.

Ayako Sera, a market strategist at Sumitomo Mitsui Trust Bank Ltd., sees the US-Japan interest rate differential persisting to some extent as the Fed is unlikely to make large rate cuts if inflation remains high and the BOJ is unlikely to will make significant rate hikes in the near future.

“It is important to assess all the adjustments and prospects of the entire BOJ monetary policy package when considering their impact on cross-border money flows,” she said.

Ryosuke Oshima, deputy general manager of the product promotion group at Mitsubishi UFJ Kokusai Asset Management Co. in Tokyo, sees yield levels as a potential trigger for a shift in flows.

“There might be some appetite for bond funds when rates go up, like 1% for the 10-year yield,” he said. “But if you look at the data, they’re unlikely to suddenly reverse all their investments at home.”

For others like 36-year-old market veteran Rajeev De Mello, it’s probably only a matter of time before Ueda has to act and the consequences could have global repercussions.

“I totally agree with the consensus that the BOJ is tightening – they will want to end this policy as soon as possible,” said De Mello, asset manager at GAMA Asset Management in Geneva. “It depends on the credibility of the central bank, it matters that inflation conditions are increasingly met now – normalization will come to Japan.”

–Featuring Winnie Hsu, Ayai Tomisawa, Hideyuki Sano, Yumi Teso, Emily Cadman and Jane Pong.

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Source : finance.yahoo.com

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