The rapid slide of the Japanese yen threatens foreign demand for US bonds, just as the Federal Reserve plans to begin shrinking its $9 trillion balance sheet.
This week, the Japanese currency hit a seven-year low, with the dollar hitting just over 125 yen. In turn, this weakness has greatly increased the cost of Japanese investors to swap dollar assets into their local currency, reducing the yields on offer from US Treasuries and corporate bonds.
Analysts at Wells Fargo estimated that Japanese investors will now have to pay 2.17 percentage points to hedge the yen against the dollar over 12 months, up 1.42 percentage points this year.
That could pose a problem for the Federal Reserve, as demand from foreign investors for US assets is seen as critical as the central bank begins withdrawing its pandemic-era bond-buying program, increasing the supply of Treasuries for investors to buy.
The minutes of the Federal Reserve’s monetary policy meeting in March showed that the central bank is keen to start reducing the size of its balance sheet as soon as May, as it looks to curb high inflation. US consumer price growth hit a 40-year high of 7.9 percent in February.
According to the Treasury, investors in Europe and Japan own nearly $4 trillion in US government debt.
“Who will be the marginal buyer of Treasury issues after the Fed,” said Tim Wessel, strategist at Deutsche Bank. “If the total cost of purchasing Treasuries is too high for these investors, it will reduce the marginal demand for Treasuries and . . . this push Treasuries yields higher.”
The sharp rise in hedging costs stems from diverging central bank policies between the United States and Japan and the relationship between benchmark interest rates and currencies.
The Bank of Japan has committed to stimulus measures to help its economy, just as Federal Reserve policy makers are signaling their intention to raise interest rates to curb high levels of inflation.
This had the effect of pushing up short-term US Treasury yields, which closely follow interest rate expectations, and strengthening the US dollar.
However, the larger difference in returns between the US and Japan also means that forward foreign exchange rates are lower than the current or spot rate. This, in turn, raises the cost of insuring the hedge, in order to once again exchange dollars for yen in the future.
“[Central bank policy is] “He’s driving the cost of hedging for non-US countries because their central banks are way behind what the Fed is doing in terms of interest rate hikes,” said Logan Miller of Wells Fargo.
Analysts said European investors keen to borrow in the euro zone and buy higher-yielding US assets were also affected by rising hedging costs.
While higher US bond yields typically increase the attractiveness of US assets to foreign buyers, the cost of protecting against currency fluctuations over the coming years has eroded much or all of the potential gains.
Strategic analysts at Bank of America predicted in late March that the extra yield an investor in Japan would gain from holding US corporate bonds would soon be completely lost if they converted it back into the yen. They added that some Japanese money managers may even decide to sell their corporate bond positions, as the costs of holding them become prohibitive.
At the moment, Japanese traders are becoming more cautious about US government debt.
“You’re seeing some investors shy away from the treasury market,” said Lawrence Ree, a price trader at asset manager TCW. “Things have moved quickly since the beginning of the year and so have they [Japanese investors] Perhaps I was surprised by the movement and volatility.”