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Long Time Devotee May Amp Up Bond Buys

NEW YORK ( TheStreet) -- U.S. Treasury bonds are losing favor amid the impasse on the deficit reduction, but there's one country that still has strong reason to buy up American debt. Hint -- it's not China. It's our second largest foreign creditor -- Japan.

With the yen at an all-time high against the greenback, Japan's government will likely want to keep appreciation at bay. Given Japan's past practices, fixed income strategists are predicting that the government might try to talk down the yen soon and undertake a currency intervention in the coming weeks. That means converting excess currency into the U.S. dollar then soaking up U.S. government bonds, still considered the asset lowest in risk worldwide.

Finance Minister Yoshihiko Noda has already hinted that Japan's central bank might take action. Earlier this week, Noda called recent gains in the yen "one-sided" due to "overseas" factors. "I will watch the market carefully and respond," he said.

Adding to the intrigue is the gridlock in Washington D.C. A downgrade of U.S. credit may push yields up and the dollar's value down.

"Since a dollar sell-off would cause a sharp appreciation in the yen, Japan could try to act earlier," says Jeffrey Bergstrand, international trade professor at the University of Notre Dame.

The last time Japan intervened was in March 2011 when the Bank of Japan reportedly bought dollars amounting to more than $25 billion. Afterwards, Asian markets rallied, shares of Japanese exporters jumped, and the greenback jumped more than 3%.

The move, which was part of an agreement within the G7, a group of the world's wealthiest countries, surprised investors. Some analysts had argued that Japan was likely to sell off Treasurys, given its need to raise money after the earthquake disaster.

The explanation behind managing the yen is that Japan's economy, like China's, depends on exports for growth. Most of Japan's GDP growth since its tech boom in the late 1980s can be attributed to the rising share of net exports. Policymakers have an incentive to keep their currency weak in order to encourage foreigners, including U.S. consumers and corporations, to buy Japanese products. However, unlike the Chinese yuan which is traded heavily for speculative purposes, the Japanese yen is traded for import-export purposes, so rather than to overly depress its currency, Japan prefers to maintain "stability" in its exchange rate.

The country intervened several times in 2003 and 2004, and in September 2010 as well. It currently holds more than $912 billion worth of Treasurys, according to most recent U.S. government data. By comparison China's holdings total about $1.16 trillion and while the gap between holdings by the two countries will likely widen, analysts still predict that Japan will continue to buy U.S. bonds.

Ian Lyngen, government bond strategist at CRT Capital, says that since the yen is stronger than it was back in March of this year, Japan may buy up more Treasurys this time around than it did last time.

"Two- and three-year bonds have been the sweet spot in the past," said Lyngen, adding that Japan's strategy has not been "entirely clear" in the past.

Japan could also buy at the longer end of the curve, notes Priya Misra, a fixed income strategist at Bank of America. Conventional wisdom says it buys only bills, but Misra says that Japan also buys five- and 10-year notes.

Demand for $35 billion worth of five-year notes was tepid in the government's last auction, indicating heightened worries that America's Triple-A credit rating is in jeopardy. The benchmark 10-year note has been bobbing around 3%, but yields on short term bills are on a sharp rise. The two-year note rose 0.35% to 0.44% this week alone.

While investors are ever so focused on how a U.S. debt resolution, or lack thereof, would affect the Treasury curve, the possibility of a Japanese currency intervention could make a small splash too.

Japan said that U.S. debt was "an attractive investment" back in April. Now we'll see how strong its commitment is.

-- Written by Chao Deng in New York.

>To contact the writer of this article, click here: Chao Deng.

>To follow the writer on Twitter, go to Chao Deng.

>To submit a news tip, send an email to: tips@thestreet.com.

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