The Name’s Bond, Japanese Bond

Weekly Briefs
20 Feb 2023
7 min read
The Name’s Bond, Japanese Bond

Last week was a busy one on the macro front. In updated forecasts, the European Commission no longer sees the eurozone economy entering a recession. On the inflation front, US consumer prices increased by more than expected last month whereas things were better in the UK, with inflation coming in less than expected. But those higher prices aren’t detering the American consumer, with retail sales rising last month by the most in nearly two years. On the crypto front, the US securities regulator agreed last week to propose expanding asset custody rules to cryptocurrencies. Finally, in what could have big ramifications for the global bond market, new data showed Japanese investors pulled a record amount out of foreign bonds last year, and comes at a time when the global bond market is back under pressure. Find out more in this week’s review.

Macro

The EU got some good news last week, with the bloc now seen dodging a recession according to the European Commission. The agency said that the eurozone economy will fare better this year than previously feared as falling gas prices, supportive government policy, and firm household spending boost the region’s outlook. The economy is now forecast to expand by 0.9% in 2023 – better than the 0.3% forecast back in November. What’s more, the commission also cut its inflation forecast for this year to 5.6% from 6.1% previously. Inflation will ease further to 2.5% in 2024, according to the forecasts. But while the outlook has improved, the agency cautioned that risks remain strong due to the Russia-Ukraine conflict.

The European Commission upgraded its GDP growth estimate for this year. Source: Bloomberg

Moving over to the US, the latest inflation report out on Tuesday showed consumer prices increased by 6.4% in January compared to the same time last year. That was slightly lower than the 6.5% pace recorded the month before, but economists had expected a bigger deceleration to 6.2%. Core consumer prices, which strip out volatile energy and food components, rose 5.6% in January. Again, that was slightly lower than the 5.7% pace recorded the month before, but economists had hoped for a bigger deceleration to 5.5%. 

On a month-on-month basis, the overall consumer price index climbed by 0.5% in January – the most in three months and a steep acceleration from December’s 0.1% – while core prices increased by 0.4%. Both these figures were in-line with economists’ forecasts. But overall, the report showed signs of persistent inflationary pressures with the annual rates not coming down as far as investors had hoped. That could push the Fed to raise interest rates even higher than previously expected – and keep them there for longer – to return inflation back to its 2% target.

Headline and core inflation both moderated on an annual basis in January. Source: CNBC

But despite high inflation, the American consumer is still in good shape with overall spending remaining robust. In fact, new data last week showed retail sales in the US rose in January by the most in nearly two years. The value of overall retail purchases increased 3% last month from the one before – their biggest gain since March 2021 and easily topping forecasts of 1.9%. Spending in all 13 retail categories rose, led by motor vehicles, furniture, and restaurants. The numbers aren’t adjusted for inflation, meaning that consumer spending outpaced the 0.5% increase in consumer prices for the month.

Retail sales rose at their fastest pace since March 2021, when vaccines were rolling out and Americans took advantage of a fresh wave of stimulus payments. Source: Bloomberg

Things were better on the inflation front in the UK, with data last week showing consumer prices rose by a less-than-expected 10.1% in January from a year ago. That’s the lowest annual increase in five months and a marked slowdown from December’s 10.5% and the 41-year high of 11.1% in October. Core inflation, which strips out volatile food, energy, alcohol, and tobacco prices, declined to 5.8% in January from 6.3% the previous month. The figure – a closely watched measure of underlying price pressures – was much lower than the 6.2% forecast by economists. Still, it’s important to keep things in context: headline inflation remains in the double digits and is five times above the Bank of England’s targeted level.

Inflation eased in January but remains in the double digits and is five times above the Bank of England’s 2% target. Source: Bloomberg

Bonds

Japanese investors pulled a record $181 billion out of foreign bonds last year and poured $231 billion into local government bonds, with sales of US debt accounting for two-thirds of the outflows. That’s according to the latest data from the Ministry of Finance and the Japan Securities Dealers Association.

Japanese investors sold a record amount of foreign bonds in 2022. Source: Bloomberg, Japan's Ministry of Finance

You can see why in the chart below, which shows the yield on 10-year Japanese government bonds (pink line) and the currency-hedged yield on US Treasuries with equivalent maturities (black line). Put differently, the pink line shows what Japanese investors can earn at home and the black line shows what they can earn in the US without worrying about fluctuations in the dollar-yen exchange rate. This allows for a fair, apples-to-apples comparison between the two bond yields. And since mid-2022, Japanese investors have been able to earn more at home, which prompted them to move a ton of cash out of US Treasuries and into local equivalents.

Even Japan’s artificially capped 10-year yield of 0.5% is more attractive to local investors compared to the minus 1.3% yen-hedged yield they would get from equivalent Treasuries. Source: Bloomberg

But these flows could be just the start. That’s because the relative attractiveness of Japanese government bonds increased even further as recently as December, after the Bank of Japan (BoJ) allowed 10-year yields to go as high as 0.5%, instead of the previous 0.25%. And with speculation rife that a newly appointed BoJ governor will allow yields to go even higher, the steady selling of overseas bonds in favor of local alternatives by Japanese savers, insurers, and pension funds looks unlikely to stop.

That could be a problem for the simple reason that there are still more than $2 trillion of overseas bonds left to potentially sell. Japanese investors own more than $1 trillion of US Treasuries and significant amounts of bonds from the Netherlands, France, Australia, and the UK. And any moves to offload more of their holdings would come at a time when the global bond market is back under pressure. Yields have started to climb once again as expectations for peak US interest rates grind higher on the back of a red-hot labor market and fears that inflation may not be quickly vanquished.

Japan's top 10 holdings of foreign bonds. Source: Bloomberg

Crypto

The US securities regulator – the Securities and Exchange Commission (SEC) – agreed last Wednesday to propose expanding asset custody rules to cryptocurrencies. More specifically, the rules would force investment advisors to secure clients’ crypto assets with qualified custodians (similar to what they already do with other client assets like stocks and bonds). The idea of the proposal is to build better safeguards around investors’ assets and comes after the collapse of several high-profile crypto companies last year revealed that customer funds were not as safe as had been advertised.

This week

  • Monday: Eurozone consumer confidence (February)
  • Tuesday: Japan, eurozone, UK, and US PMIs (February). Earnings: Home Depot, Walmart, Coinbase
  • Wednesday: Minutes of the Fed’s latest meeting. Earnings: Nvidia
  • Thursday: Earnings: Alibaba, Moderna
  • Friday: Japanese inflation (January)
General Disclaimer
The information and data published in this research were prepared by the market research department of Darqube Ltd. Publications and reports of our research department are provided for information purposes only. Market data and figures are indicative and Darqube Ltd does not trade any financial instrument or offer investment recommendations and decision of any type. The information and analysis contained in this report has been prepared from sources that our research department believes to be objective, transparent and robust.

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