Credit: Japan Hikes, US Debt Spikes. What Now for Bonds?
It's all about the debt
Chief Investment Office, Daryl Ho22 Mar 2024
  • Risks we have called attention to include latest developments in Japan ending negative rate regime
  • As well as US debt seeing rapid escalation
  • These continue to suggest a regime of diminishing demand & higher supply of US debt
  • Which could lead to rising term premiums and steeper yield curves
  • Stay short-duration, against more common inclination to take long-duration positioning
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Higher rates, higher debt. At long last, the world exits its last negative rate regime as Japan raises its policy rate – the first in 17 years – to a smidge above zero (0-0.1%). Equally, if not more significantly, the Bank of Japan (BOJ) abandoned yield curve control (YCC), leaving the door slightly ajar for market forces to influence the supply/demand of Japanese government bonds (JGBs). Across the Pacific, headlines around the US indebtedness continue to unnerve bond markets; the latest being that the US national debt is growing at about USD1tn nearly every 100 days. How are these two seemingly unrelated developments related to fixed income strategy?

The answer relates to demand and supply. On the demand side, the structural drift higher in Japan’s onshore yields and undemanding equity valuations would render domestic assets more attractive than those abroad, a risk we highlighted in early 2023. In other words, Mrs. Watanabe – the stereotypical term for retail Japanese yield-seekers – would no longer need to shop abroad for yields if onshore rates become much more desirable as Japan normalises policy. This is unfortunate news as Japanese investors are amongst the largest exporters of capital in the world. Particularly for US Treasuries, Japan as a nation is the single largest foreign holder of US debt, amounting to more than USD1.1tn at present.

It’s all about the debt. This could not come at a worse time as US debt supply continues its rapid ascent. This latest alarming spike of US debt above USD34.5tn should not surprise us any longer; we highlighted the mechanism of how high policy rates affect deficits last year, concluding that the trajectory of US debt was unsustainable.

Why hasn’t QT affected liquidity? With this rising debt supply, one would have thought that the Fed’s quantitative tightening (QT) would have more rapidly drained liquidity in the system; yet financial conditions have remained comfortable thus far. Looking into the details, we see that banking system liquidity had remained unscathed since the start of QT in mid-2022 largely due to the presence of the Fed’s reverse repo facility (RRP), which has acted as a “shock absorber” shielding systemic liquidity from drawdown. This we believe has supported the functioning of treasury markets. This RRP facility is set to be drained by Jun 2024, exposing bank reserves to the full impact of QT which could impact systemic liquidity. We believe it is with this risk in view that the Fed had started to talk about tapering its balance sheet run-off in this recent March FOMC meeting.

Figure 1: Banking system liquidity was shielded from QT by the RRP

Source: Bloomberg, DBS

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Note: All views expressed are current as at the stated date of publication


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