On the back of two decades of low interest rates, Japanese investors have had to seek yield elsewhere. Buying government securities in foreign markets has been a natural alternative, especially in developed market countries with negligible credit risk. However, hedging out the risk of buying foreign currency securities by selling yen has typically come at a cost. Hence, the dynamics of Japanese flows have been dictated by this “hedged yield” pickup available in other developed countries.
Hedged yield pickup is naturally governed by the relationship of the spot and forward FX rates, which in turn are driven primarily by short-term interest rates. As market expectations of rate hikes have accelerated globally due to an increase in inflation, the anticipated hedged yield pickup for Japanese investors is also expected to change as the Bank of Japan is unlikely to raise rates commensurate with global peers.
Looking at these implied hedged yields, we believe market anticipation is leaving Japanese investors in a unique position. The hedged yield surplus over Japanese nominals is priced to dissipate across developed markets due to the aggressive hiking being priced in, along with the continuation of flattening yield curves. Looking at market expectations for year-end 2023, many developed market names including the U.S, U.K and Germany are priced to offer hedged yields below the forward Japanese 10-year yield. The exception is Italy, where the forward pricing of yields offsets the increase in hedging cost from ECB rate increases.
Prior to the bolstering of demand by quantitative easing, Japanese demand for sovereign debt had notable implications for the path of interest rates. As central banks continue to taper asset purchases, we can expect much of this demand from Japan to return. This has already become evident with increased flows in the last six months into Italy, despite the availability of surplus hedged yield from more conventional sources.
Going forward, we expect a recalibration of Japanese flows as central banks are inevitably pushed to raise rates and hedged yield gaps converge, dissuading foreign investment and redirecting flows to domestic markets and into corporates. We can expect flows to be diverted to investment grade credit assets for a yield pickup and European corporate hybrids on the back of expectations of a delayed hiking cycle by the ECB, validated by Lagarde’s comments on Thursday. As tapering reduces Treasury demand, this dynamic could have a prominent effect on how rates evolve globally.