FX: G10 & EM, published every Thursday, provides a detailed analysis of global foreign exchange movements in major and emerging economies around the world together with macro insights.
Geoff Yu
Time to Read: 5 minutes
EXHIBIT #1: INBOUND FDI VS. JPY NEER (INVERTED)
Source: Macrobond, BNY
Our take
The political dust has not yet settled domestically from the Japanese upper house elections on July 20, but the market verdict suggest that such considerations will not have a major impact on asset performance. Two key developments support a strongly improved outlook for the economy. Firstly, irrespective of its composition, the government’s leadership will have to acknowledge economic considerations highlighted by voters. Going for growth will be a priority and renewed fiscal impulse is inevitable. Current Finance Minister Kato has stressed that the government will aim for “economic revitalization,” but also acknowledged that fiscal considerations have impacted bond market flows and yields, and vowed to “work toward gaining trust form markets.” Given the traditional approach in Japan is to maintain loose monetary policy to support fiscal expansion, the natural reaction for markets is further JPY weakness, or at least a slowing of JPY strength. This will ensure that Japanese assets remain attractively valued for cross-border investors.
Forward look
We maintain the view that JPY needs to strengthen over the longer term, and concerns over imported inflation were one of the main reasons for the government’s poor performance in the elections. Meanwhile, the U.S.–Japan trade deal will also remove a key source of uncertainty for the Japanese economy. While the final deal still implies a higher cost for U.S. consumers of imports from Japan, the levels are manageable if some degree of nominal effective exchange depreciation takes place as an offset. Another key component is President Trump’s claim that Japan will open up its economy further. This, coupled with current valuations, foreign inflows and direct investment, will continue to strongly support the financial account. Recent difficulties in foreign takeovers notwithstanding, we note that FDI in Japan has surged in recent years as the JPY’s NEER weakened significantly (Exhibit #1). A weaker JPY was seen as ample compensation for structural issues which had traditionally hindered such investment. The same would apply to other assets on the financial account. We agree that greater openness to foreign investment on Tokyo’s part could be a major achievement of the agreement.
EXHIBIT #2: DISTRIBUTION OF OWNERS OF JGBS (¥TN AND %), END-2023
Source: Japan Ministry of Finance, BNY
EXHIBIT #2: DISTRIBUTION OF OWNERS OF JGBS (¥TN AND %), END-2023
Source: Japan Ministry of Finance, BNY
Our take
Traditionally, FDI and equities have generated cross-border interest, but in recent years, as yields have risen to more agreeable levels, foreign interest in the large and liquid JGB market has been notable. At the end of fiscal 2013, foreign holdings of JGBs amounted to only 8% (¥78.4tn) of the total amount outstanding. A decade later, the latest debt management report for 2024 indicates this figure has risen to 13.5% (¥165tn) of outstanding JGBs on issue, more than double the level a decade ago. Using year-end exchange rates, this represents a rise of almost $400bn. However, the distribution of holdings points to a sharp divergence in preferences, and calls into question whether JGBs are considered attractive from a total return perspective. The debt management report indicates that the vast majority of foreign holdings are in T-bills, at ¥92.2tn, whereas JGB holdings only amount to ¥72.2tn (Exhibits #2 and #3). Foreign investors only account for 6.7% of the JGB market, but 66% of the Treasury bill market. Given the low yields for the latter, such holdings are most likely for cash management purposes, and the move away from negative rates has made them less punitive to hold on an outright basis. JGB yields continue to rise, but given the past five years of exceptional dollar and yield performance, we understand the market’s current limitations.
Forward look
Even under best-case scenarios, Japan’s long-term bond yields will unlikely challenge peers in developed markets. Term premia will remain low due to high levels of savings and net foreign assets, which explains why foreign interest has largely been concentrated in the ultra-long space. Meanwhile, inflation premia will move commensurately with JPY weakness and associated pass-through risks, but ultimately the BoJ’s dominant current and future position in markets will be sufficient to manage any associated volatility. As plans for quantitative tightening are now less hawkish, it is evident that long-dated JGB yields require subtle management, and policymakers continue to believe that JPY volatility is manageable. Front-end adjustments through interest rates will continue over time, which will increase the marginal attraction for foreign investors to complement the cash management component associated with higher levels of asset allocation in equities and other instruments. We do not see the composition of foreign holdings for JGBs changing materially in the future – the barbell of cash and longer dates will remain in place.
EXHIBIT #4: ROLLING 12-MONTH JGB INFLOWS, OFFICIAL DATA VS. BNY CUSTODY FLOWS
Source: BNY, Macrobond
Our take
Official data indicate that on a rolling 12-month basis, interest in JGBs have started to improve this year, a further indication that foreign investors remain highly sensitive to yield developments. The rolling sum has reached flat for the first time since mid-2023, but this remains well below 2022 levels, when global rates started to move aggressively due to growing inflation risks arising from supply issues and energy bottlenecks. However, Japanese inflation at that point was purely due to tradables and commodities, and Japan’s trade surpluses were heavily eroded as a result. The corresponding fall in Japanese real yields did not support the JPY initially and intervention was even required in Q4 2022 to manage volatility.
Forward look
More recently, we believe the right balance for JGBs has been attained, whereby yields are high but sufficiently compensated for by attractive JPY valuations. Even with trade deals across Asia, we expect a structural shift in policymaking across the region to support better domestic demand, and in time a stronger JPY will be part of the process as the continent’s households start to run down overseas savings, or at least generate smaller surpluses to channel overseas. This will help fundamentally shift balance of payments and anchor real yields without undermining nominal yields – a departure from previous experiences of high real yields only due to very weak inflation. This dynamic does make JGB purchases more attractive for long-term overseas investors. Our iFlow data for cross-border JGB flows track the official balance of payments data well, and on 12-monthly rolling basis the figure has also turned positive for the first time in three years. Near-term weakness in the JPY to support growth and yields is arguably just the catalyst needed for longer-term strength and higher foreign allocations of Japanese assets, though we acknowledge that Japanese authorities are probably ambivalent about these trends.
We do not expect material changes in domestic or trade policy in the near term as a result of the election. Financial conditions will remain loose to support growth, but structural changes in the JGB market, especially inflation premia, can set the foundations for higher levels of foreign investment over the longer term. Better access and market infrastructure (the Japan Securities Clearing Corporation is introducing an agency model for offshore investment firms seeking to clear transactions), higher nominal yields and attractive JPY valuations have lifted cross-border interest in JGBs, and our data indicate momentum will strength as long as such shifts are reinforced.
