Haruhiko Kuroda, Governor of the Bank of Japan. Image via World Economic Forum
Japanese investors have long been supporters of the European Economic and Monetary Union (EMU) deflation trade and by all accounts are now holding excessive positions in the EMU’s semi-core bond markets. For example, Japan now holds 12% of all French sovereign bonds. It isn’t only political risks which pose a risk to these investors; the EMU is also developing inflationary pressure within its core economies while at the same time, periphery economies continue to battle deflation which sees local funding costs rising at a quicker pace than local inflation rates.
Bond Market Volatility To Challenge Japanese Investors
In the run-up to the March 15th Dutch elections and the French Presidential elections in April and May, Japan’s real money investors could find it increasingly challenging to maintain exposure. Returns are likely to be weakened by recent bond market volatility, increasing the potential desire for the liquidation of positions. For example, Japanese exposure to US bonds was near record highs when US bond yields exploded higher in Autumn last year.
As a large percentage of these positions were FX hedged, the stronger USD didn’t compensate for capital losses. The high EUR FX hedge ratio for Japanese real money, which was over 80% in 3Q 2016, suggests that there might not be a substantial direct EUR weakening effect in the event of Japanese liquidation. The threat to EUR will be more indirect this time, coming via rising EMU bond spreads and their subsequent impact on financial and economic stability in the EMU.
Read More: https://www.orbex.com/blog/2017/02/usdjpy-to-break-120/