One week / one topic: Sumo yields

What happened?

Something is not right with Japanese government bonds. (JGBs)

For context, 10yr yields usually reflect market expectations for a country’s long-term economic growth, inflation, and central bank policy – with higher yields usually signalling optimism about growth or rising inflation.

After the 2016-2021 era of yield curve control and zero-bound yields, investors are now clearly pricing something quite different for Japan.

In the search for more clues to understand what’s going on, we can also focus on the 3-month / 30-year spread, which represents the difference between short-term and long-term government bond yields and is essentially showing the slope of the yield curve.

Again, a steep positive slope usually signals expectations of economic growth and inflation over time, while a flat or inverted slope often reflects market concerns about slowing growth or a potential recession.

Once more, we can observe that Japanese yields are behaving quite differently from comparable G7 peers, and indeed this measure has also been steadily rising since late 2021.

As of late, however, we have also observed sharper and less correlated moves in Japanese yields – especially at the long end of the curve.

Lo and behold, there is of course a conveniently available narrative to fit the price action: not only Japan’s newly elected Prime Minister Sanae Takaichi embodies a strong discontinuity on both a personal and policy level, but a recent spat with China also brought to the surface further geopolitical concerns which could plausibly lead to more defense spending and fiscal expansion.

When we then look at a measure of liquidity for government bonds – tracking the average deviation of bond yields from a fitted fair-value curve, where higher values represent increasingly stressed liquidity – Japan once again stands out.

(We’ll talk about the UK another day)

Japanese bond liquidity stress then likely reflects heightened policy uncertainty, heavier issuance with fewer Bank of Japan purchases, inherently thin market depth, and idiosyncratic factors around the behavior of large buyers like local insurance companies.

So – while you are clearly getting compensated more and more for taking a position in JGBs – the multi-year, steady rise in yields leads to an obvious question: are we there yet?

Or could there be more attractive yields on offer for those who wait?

Our observations

• Fundamentals: As far as fiscal and inflation dynamics go, the recent climb in JGB yields looks directionally correct. But is it all already in the price? Very hard to say, especially as 30yr nominal yields sit at multi-decade highs.

• Price action: While hedged yields are already in attractive territory for US and European investors, the wild volatility in the Yen does not inspire a lot of confidence.

• Investor beliefs: Most investors active today have been able to ignore JGBs for the longest time. This might raise the bar in terms of what it would take to capture their attention, but it could also lead to a ‘tipping point’ moment if and when they suddenly conclude that not owning these bonds is indeed an active decision…

So what?

Putting it all together, what seems to be missing before actually taking a bite at JGB yields is a heightened sense of crisis.

While of course every case is different and one should avoid complacency, G7 money-printing sovereign issuers do not default that often… which implies that – should Japanese yields spike violently, as opposed to gradually but protractedly as they have been– there could be attractive opportunities to buy these bonds.

You would of course then be left with the pesky problem of currency exposure, but hedging cost are actually negative and this would therefore boost returns for USD- or EUR-based investors. (However, roll risk)

We have seen higher levels in the recent past, but hedged yields remain not far from the peaks of 2023-2024.

Mood music: ONE OK ROCK – Prove

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