Japan Signals End to Negative Interest Rates, Will It Continue Investing Abroad?

Japanese officials signal the end of negative interest rates, which is quite significant news considering that local investors are among the largest exporters of capital in the world.

Over the past decades, they have become major buyers of U.S. Treasury bonds, European fixed-income bonds, and other foreign bond markets. With domestic yields being so low for so long, and Japan continuing to accumulate savings and foreign reserves, Japanese investors have sought ways to invest abroad to achieve higher returns.

For reference, Japanese investors alone hold over one trillion dollars in U.S. Treasury bonds and about 400 billion euros in various European bonds (mainly French and German).

For more than a year, there have been whispers that the Bank of Japan (BOJ) would raise rates, but this has not yet happened as it has patiently waited to see if global economies are truly capable of enduring high rates for an extended period, experts believe.

The way Mitsubishi UFJ Financial Group views this is much ‘more definitive’ than the view of the swap market, which assesses the chances that BOJ Governor Kazuo Ueda will change policy this month at around 50 percent, Bloomberg reported. When it changes course, it will have significant implications for the $7.3 trillion government bond market, and consequently for the national currency.

Avoiding Currency Risk

– I think it is necessary to abolish the negative interest rate in March, not in April – said Hiroyuki Seki, head of global markets business at MUFG, in an interview.

Seki’s reasoning is that the BOJ will likely make an additional increase to raise the interest rate to 0.25 percent by October at the latest ‘to ensure future policy flexibility’ after raising rates at its next meeting on March 19 for the first time since 2007.

The BOJ ‘needs to ensure enough time before the next rate increase,’ he said.

This is a necessary condition for Japan to exit negative interest rates: if it does so while global economies are performing well, it will prevent a rapid appreciation of the Japanese yen and thus avoid a return to deflation in the country. Now that domestic yields in Japan may be on the rise, will they stop investing in foreign bonds?

Namely, when Japanese investors buy foreign bonds, they first have to expose themselves to currency risk, which they often avoid. This is why Japanese investors hedge against the currency risk involved in purchasing foreign bonds, and based on what can be concluded from the experiences of Japanese investors, they continuously hedge currency risk over periods ranging from three months to one year.

For Japanese investors, U.S. Treasuries have become extremely expensive to hold. This is because the costs of hedging against exchange rates are super high, primarily due to the Fed’s rate hike cycles and inverted yield curves in the U.S.

What will happen if the BOJ raises interest rates, making domestic bond investments more attractive for Japanese investors? That remains to be seen.