Even with global stocks reaching new record highs almost daily, the money flowing into global bond markets and falling yields has been the more surprising fact this year. As global Central Banks cut rates in the face of the coronavirus, or flood markets with liquidity, much of the cash is finding its way into bonds all around the world, despite low yields and robust economic growth.
Watching decisions of certain large participants provides some clues to what might be going on.
A highly watched participant in the market is Japan’s Government Pension Investment Fund (GPIF), the largest public pension fund in the world, with over $1.5 trillion worth of assets. This fund invests globally, and late last year announced that it would re-classify currency hedged foreign bonds as domestic bonds (Source: Nikkei, September 30, 2019). By currency hedging, negatively yielding European bonds are turned into positively yielding bonds for the duration of the currency hedge (which is usually much shorter than the maturity of the bonds).
So, for example, and as I wrote about last year, this move could justify the buying of larger quantities of negatively yielding European bonds on the basis of yield, since they could now be classified as domestic Japanese bonds.
According to various reports from dealers (as of Feb. 19, 2020), in January of 2020 foreign pension funds purchased a record high of almost $19 billion of unhedged foreign bonds. Estimates are that this week the GPIF will be changing its foreign bond asset allocation to 25% of its holdings, which would require the purchase of six times, i.e. almost 12 trillion yen (or over a hundred billion dollars), worth of unhedged bonds over time. This is a very large number indeed and could be consequential for the US dollar versus the Japanese yen.
Let us dig into this a little bit.
The Japanese government is printing money as part of an almost two decade long monetary stimulus program. This started with the ZIRP (zero interest rate policy) in late 1998; then Abenomics (2012); QQE, or “Quantitative and Qualitative Easing” (2013); QQEE or expanded QQE (2014); NIRP or “Negative Interest Rate Policy” (early 2016); and “Yield Curve Targeting” (late 2016), which has expanded the balance sheet of the Bank Of Japan to over five trillion dollars.
As a consequence, in Japan, two to ten year yields are negative, and thirty year bond yields are a measly 0.4% (Source for all data: Bloomberg). On the other hand, due to the negative deposit rates in Europe, a Japanese investor now has a currency hedged yield of about -0.44% on two year German Bunds, and 0.34% on thirty year German Bunds. Investing in Italy on a currency hedged basis results for a Japanese investor results in zero yield for two years, and a little over 2% (2.15%) for thirty years, with all the political and credit risk of Italy that comes with it. The Japanese are on a demographic trend, and elderly citizens need guaranteed yield for retirement.
Given the alternatives, the same Japanese investor gets 1.4% on a US two-year treasury on a currency un-hedged basis (and -0.53% on a currency hedged basis). For a US thirty year treasury bond the Japanese investor gets a yield of about 2% on a currency un-hedged basis (and only 0.05% on a currency hedged basis). Even without taking any bond duration risk, the three month T-Bill unhedged yields in the US is almost 1.6% (Source for all data: Bloomberg), which should look darn good in comparison to negative European yields as long as the currency risk can be managed.
The decision facing a large public pension which looks for yield today is to make a balanced choice between taking currency risk by investing in the US on an unhedged basis, or taking no currency risk, but taking bond price or duration risk by investing in European bonds.
It is my opinion that as long as the world is willing to let Japan print money and buy foreign assets, the currency risk ought to be minimal. For now, the currency options market seems to agree, as the implied volatility on the US dollar to Japanese yen exchange rate has crashed to a two decade low (Source: Bloomberg). Thus, with no currency risk, investing in the US bond market will likely be the preferred investment destination for market participants going forward.
To see this simply, let us imagine an extreme scenario. Assume that all US bonds were trading at exactly zero yield. Then a foreign pension with access to a printing press could simply buy a ladder of treasury bonds with maturities from a few months to a few decades. As the shortest bonds mature, they would use more freely available cash to extend the bond ladder.
By doing this, the foreign investor has created a zero coupon ladder where the coupon is simply the proceeds from the maturing bonds. If the yield is positive as it actually happens to be in the US, then the total yield on the ladder is even more valuable than the zero coupon ladder.
There are currency risks. If the yen weakens substantially then this would require more yen in order to maintain the ladder. However, from a public welfare perspective, a weakening yen is positive for the Japanese export sector, and for a nation that relies heavily on trade, this would likely be a positive. On the other hand, if the Yen were to strengthen substantially, a larger ladder of US treasury bonds could be constructed with the same amount of yen, and the buying of dollars for yen would likely slow down, if not stop, any yen appreciation. As long as politics allows it, the yen’s appreciation will be “managed”.
In other words, given implicit access to the benefits of the yen printing press, the GPIF’s actions to move toward currency unhedged bonds is likely to be very positive for the US treasury bond market. In the short run, the willingness of market participants to allow Japan to run a very high debt to GDP ratio without penalizing the currency leads to this state of affairs as being the path of least resistance. And yes, let’s not forget that it allows the US to have a willing buyer of its debt which can fund the increasing US fiscal deficit and allows Japan to keep the yen weak. In the short run, at least, it’s win-win for both parties.
Is there a loser, and if so, who is it? My view is that the largest beneficiaries of currency hedged bond buying (so far) have been European bond markets, which have been able to get away with offering low and negative yields due to the currency hedging yield pickup. If the re-allocation toward unhedged US bonds occurs, as I expect it to, the US dollar would likely be the biggest beneficiary, and the Euro and its sibling low yielding currencies and their bond markets would likely be the biggest losers.
If negative yields cannot be turned into positive yields via financial engineering as has recently done via financial alchemy, someone else has to be willing to step up to purchase European bonds. With very little prospect of earning much yield from them, these private buyers might be hard to find. Public buyers like the ECB might have to continue to be the buyers of last resort. The question for every investor is whether Central Banks can permanently keep bond markets propped up. The fate of the bond markets and by extension most risky assets that have been the beneficiaries of low yields depends on the answer.