The specter of Japan, the world’s largest holder of U.S. debt, pulling back its investments has been a lingering concern for American bond markets. Yet, despite the Bank of Japan's (BOJ) shifting stance on it's zero-rate policy, the U.S. debt market may have already navigated the brunt of this challenge. As Japan potentially moves towards raising interest rates next year, analysts have feared a repatriation of Japanese funds. However, the reality is more nuanced, with key players in Japan’s carry trade, such as banks and pension funds, largely insulated from direct impacts due to their hedging strategies.
The dynamics of the carry trade, a product of Japan’s long-standing ultraloose monetary policy, are critical to understanding this non-issue. Institutions engaging in this trade often hedge currency risk, focusing not on the absolute rate differentials but on the hedged returns. Despite high unhedged U.S. Treasury yields, the carry trade has been unprofitable since mid-2022 due to costly hedging operations linked to the inverted U.S. yield curve. Evidence shows that Japanese institutions have indeed been reducing their U.S. bond holdings, but more recent data suggests a reversal, with Japan resuming its role as a net buyer of international debt as hedging costs have moderated.
Interestingly, the future of U.S.-Japan financial dynamics could be influenced by the shape of the yield curve. If the U.S. and German yield curves steepen, it may counteract any tightening from the BOJ, especially if the Federal Reserve and the European Central Bank halt rate hikes or even transition to cuts. Furthermore, the major Japanese institutions that do not hedge their holdings, like the Government Pension Investment Fund, have been conservative in their U.S. bond investments, making a sudden withdrawal unlikely.
Investors in the fixed-income market must navigate numerous challenges, but the Japanese withdrawal from U.S. bonds appears to be an overstated risk. The underlying hedging practices of Japanese investors have created a cushion against rate policy shifts, and recent trends indicate that Japan's appetite for U.S. debt is far from waning. This resilience provides a measure of reassurance about the stability of the demand for U.S. bonds, even as the world's financial landscape continues to evolve.
