The Bank of Japan’s surprise policy tweak sent US government bonds down sharply, but US Treasury Secretary Janet Yellen probably hasn’t seen anything yet.
As the BOJ allows the yen to appreciate at long last, Yellen’s team may soon find itself short of buyers for US Treasuries in Asia and beyond.
As Japanese government bond yields rise, it will spark more selling of US Treasuries by Japanese institutional investors. As the dollar-to-yen trade gains momentum, more and more Japanese investors will redeploy their cash into the domestic bond market.
Yet Washington’s demand troubles could be far bigger than that.
Japan, after all, is the top holder of US government debt. China is No 2, followed by the UK and Belgium. If the BOJ is serious about stepping away from quantitative easing and tolerating a stronger yen, why would Tokyo buy sizable blocks of US Treasuries going forward?
Why, it follows, would China add to its dollar stockpiles given President Xi Jinping’s stated goal of internationalizing the yuan and accepting a rising currency? Why might the UK, Germany or US banks continue buying Treasuries given the fiscal trajectory of President Joe Biden’s economy?
At the same time, the Federal Reserve is engaged in its most aggressive tightening in nearly three decades: Washington’s debt load now exceeds a record US$31 trillion. Add to that the highest US inflation in 40 years amid speculation of a recession in 2023.
The need for increased fiscal stimulus to combat contraction would increase the US debt load. That, in turn, would further reduce the appeal of Washington’s IOUs. And the BOJ revamping its yield-curve control (YCC) policies could signal an inflection point spelling trouble for the globe’s most important debt market.
“Each incremental increase in the YCC band will be a bearish impulse for the US,” says strategist Ian Lyngen at BMO Capital Markets.
In the short run, it’s not entirely sure how things might play out. Lyngen notes that “the law of diminishing bearishness applies as the ‘shock’ value of the current move will be the highest,” suggesting there might be a limit to how higher Japanese government bond yields will affect US rates.
Yet, the BOJ’s surprise “on the margin” move is likely to reduce demand for Treasuries and other US debt, says Brian Svendahl, a portfolio manager at RBC Global Asset Management. Svendahl views this as more of a “longer-term story rather than a short-term shock.”
Economist Louis-Vincent Gave at Gavekal Research says that “putting it together, it’s hard to avoid the conclusion that the BOJ’s shift in policy, and the introduction of more policy uncertainty, reinforces the most important structural trend already established over the past year, namely, a move towards higher global yields.”
Gave adds that “all else equal, a stronger yen should push yields higher. But all else is not equal since Japanese savers and corporates tend to keep big positions in foreign bonds, especially US Treasuries. Hence, a stronger yen should cause a degree of capital repatriation into Japan.”
It follows, though, that Washington’s assumption that its bankers in Asia will always have its back needs revision. The US may have built a large and innovative economy on a hill, but Asia’s central banks hold the deed.
The top 10 Asian holders of US Treasury debt are sitting on $3.5 trillion worth. The biggest — Japan and China — hold $1.1 trillion and $910 billion, respectively.
The Asia-will-be-there assumption worked for Biden’s predecessor Donald Trump. It worked for Presidents Barack Obama, George W Bush and Bill Clinton, too. Both Trump and Bush, for example, tapped Asian savings to fund trillions of dollars of tax cuts. Asia’s cash financed Obama’s plan to revive the US after the post-subprime crisis.
In the years since Trump launched a trade war against China, Xi’s government has been methodically trimming its exposure to US debt. Moscow, too, despite Trump’s very public affection for Russian leader Vladimir Putin. Xi’s success in internationalizing the yuan can be seen in the rapidly rising trade between China and Russia.
It hardly helps that Asia harbors a certain amount of PTSD from the last time the Fed was tightening as aggressively as it is now. Back then, in the mid-1990s, the resulting jump in US yields rocked Asia to its core.
Within a few years, currency pegs were impossible to defend. First Thailand ended its baht peg to the dollar. Then Indonesia, followed by South Korea. Malaysia, too, was pushed to the economic brink.
Now, US Fed Chairman Jerome Powell’s team is hiking interest rates with an urgency similar to the Alan Greenspan-led central bank nearly 30 years ago. It’s driven yields on 10-year US Treasuries to 3.7%. With inflation rising the fastest since the early 1980s and the US national debt skyrocketing, can 4% or even 5% yields be far off?
In March and April, Yellen’s Treasury Department staged a couple of weak government debt auctions. Below-average “bid-to-cover” ratios at both auctions bore the fingerprints of foreign central bankers turning on Washington’s IOUs. That was followed by further weak debt sales in September and November.
Surging US rates could backfire on Asia in four ways, namely: massive fiscal losses would leave Asian governments deep in the red; chaos for export-driven economies; a loss of confidence among foreign investors; and a major pivot away from the dollar by Asian central banks.
This latter risk has preoccupied Asia since the 2008 Lehman Brothers crisis. One year after Wall Street nearly collapsed, then-Chinese premier Wen Jiabao said Beijing was “concerned about the safety of our assets” and urged the US “to honor its words, stay a credible nation and ensure the safety of Chinese assets.”
By 2011, S&P Global Ratings showed global markets what Wen was worried about when it yanked away Washington’s AAA status. The question now, as US debt and inflation surge simultaneously and political polarization in Washington deepens, is whether the Biden administration could face history’s biggest margin call.
The BOJ’s possible policy U-turn adds a new wrinkle. It suggests that Washington can no longer take for granted that Japanese demand for Treasuries will remain consistent.
As economist Padhraic Garvey at ING Bank puts it, “it seems the only way is up for market rates.” The latest move by 10-year yields toward 4% “is yet more confirmation that the low-rates environment is very much behind us.”
The same goes for Washington’s ability to rely on Japan as its top customer for US Treasuries. The BOJ’s tweak this week is a shot over the US market’s bow.
Follow William Pesek on Twitter at @WilliamPesek