Saturday, October 22, 2016

A New Home for Government Bond Investors

With the current monetary policy stance of the Federal Reserve System, and the tone being conveyed by the Fed's forward guidance, and market expectations for the path of monetary policy normalization in the United States, the exodus out of US government debt has begun. Net selling of bonds by investors tends to increase the market interest rate associated with the bond, which is in-line with the overall direction on monetary policy in the US. In anticipation of this, some investors adjust their portfolio allocations to reflect the expected downside to bond prices.

For those investors however, that must maintain their allocated levels of different asset classes, the expected downside for US government bonds means they need to find somewhere else to park their investment capital. An ideal candidate is Japanese Government Bonds (JGBs). Conceptually, the same reason why there will inevitably be a capital outflow from US government, is the reason why there will inevitably be a capital inflow into Japanese government debt.

Interest rates and bond prices move in opposite directions, therefore, the Fed raising interest rates will depress the prices of US government bonds, meanwhile, the Bank of Japan is firmly committed to Quantitative Easing and has no plans to raise interest rates any time soon. This monetary policy stance by the Central Bank supports the prices of Japanese government bonds, as these bonds are used as collateral for cheap money from the Central Bank. As an added bonus, the long-term deflationary trend of the Japanese economy means the future cash flow from the government bonds should have more purchasing power than the cash used to purchase the bonds. This should supplement the low nominal yield earned on the bonds.