New Risk Threatening the US Treasury Market? How Much Will BOJ's YCC Tweak Matter?

Following the Bank of Japan's announcement of a more flexible approach to controlling 10-year government bond yields, with the 1% level being cited as a reference point now, Reuters reported last Thursday that BoJ Governor Kazuo Ueda is planning to exit the decade-long ultra-loose monetary policy at some point next year. The market is anticipating the end of Japan's easing policy.

However, the outlook might not be as rosy as it seems. This week, the US Treasury yields have experienced a slight uptick, thereby causing concern among analysts who are sounding the alarm that the Treasury market is still struggling to cope with various impending challenges. They have issued a warning that Japan's exit from monetary easing measures, including the Negative Interest Rate Policy (NIRP) and Yield Curve Control (YCC), could pose another hidden risk for the US bond market.

As of August 2023, Japan holds a position of $1.1 trillion in U.S. Treasury securities, remaining the largest foreign holder of such securities and granting it considerable influence over the U.S. Treasury market. Moreover, there is also a significant amount of Japanese money in US corporate debt. As of the end of August, foreign investors held more than $4.1 trillion in U.S. credit, with Japan being one of the most prominent among them.

If the Bank of Japan were to exit its Yield Curve Control (YCC) and allow for higher yields on its 10-year Japanese government bonds (JGBs), this could further narrow the interest rate difference between Japan and the United States. As a result, investors may withdraw their investments from the U.S. market and shift them towards Japan instead, exacerbating the supply-demand imbalance for U.S. debt and potentially increasing volatility in the U.S. bond market.

Investors who rely heavily on the low-cost Japanese yen for dollar-yen carry trades may become less willing to invest in US Treasury bonds due to the possible increase in leverage financing costs and decreasing yield differences that could narrow profit. As a result, selling pressure in the U.S. Treasury market may intensify.

According to Goldman Sachs' Kenneth Ho, the BOJ's YCC revision is unlikely to significantly impact Japanese demand for dollar bonds. This is due to the extensive size and scope of US credit markets, which make it difficult to find comparable alternatives, putting a floor on foreign net purchases.

A sudden move from US fixed-income investments to domestic options would require a mixture of a significant strengthening of the Japanese yen, an even steeper JGB yield curve, and a considerable narrowing of the yield differential between USD bonds and Japanese government bonds. “The bar is remarkably high, given the starting levels for both the JPY and the yield differential.”

The low volatility and low exchange rate of the Japanese yen are key factors that make the yen carry trade attractive to investors. Therefore, compared to the limited impact resulting from YCC language adjustments and rising Japanese government bond yields, Goldman Sachs analysts believe that foreign exchange hedging costs are the bigger driver in Japan's purchase of U.S. dollar bonds. They noted that a noteworthy surge in hedging expenses caused substantial net-selling activities last year, as it was no longer appealing for investors to purchase dollar-denominated bonds that were hedged against the yen. Data compiled by Nomura Orient International Securities showed that Japanese investors sold around $113 billion in U.S. long-term bonds in 2022, marking the biggest annual sell-off since 2017.