Mounting Japanese Debt Could Pressure Bonds in '99

The yen's rise against the dollar is also a negative for the U.S. market.
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A massive selloff in Japanese government bonds two weeks ago, spiking the yield on the benchmark 10-year bond up more than 70 basis points to about 2%, was a harbinger that rattled the U.S. Treasury market. The plunge in Japan was an early reaction to the anticipated influx of 71 trillion yen in new JGBs this fiscal year, double the amount sold in 1998.

That supply has to be eaten up somehow. And Japanese bond yields are expected to rise further in anticipation, similar to the "crowding out" theory propounded in this country when the U.S. took on a mountain of debt in the 1980s. Coupled with the yen's recent strength against the dollar, this could pressure longer-dated Treasury bonds in the coming months, analysts say.

"It's got to take away from Treasuries -- there's more to be absorbed by the public sector," says Tony Crescenzi, bond market strategist at

Miller Tabak Hirsch

. "Yield spreads between JGBs and

U.S. 10s are at the narrowest since March 1996. ... The Japanese investor has to take on a currency risk; that's why when the spread is narrower. It takes away from buying" Treasuries.

In the past four months, the difference in yield between the Japanese 10-year benchmark and the 10-year Treasury bond has narrowed to 290 basis points from 395 basis points. The JGB yield has risen to 1.91% from 0.9%. The higher yields have renewed interest in the Japanese bond market and hurt the already weakened dollar. If the dollar continues to slide, it will lead to more selling of Treasuries by Japanese investors to hedge against losses in their own bond market.

When viewed in real rates -- that is, the yield on the bond minus the core rate of inflation -- Japanese and U.S. bonds are now yielding about 3%, when just two months ago real yields in Japan were around 2% or less.

In the same four-month period, dollar/yen has declined to 111.48 from 139.25, and it hit a 27-month low of 111.01 yesterday. The dollar has been steadily weakening since the summer, and analysts don't expect it to recover soon. The currency has also declined against the French franc and the German mark in the past four months.

"This is directly tied to the dollar," Crescenzi says. "The JGB situation -- it is important, and it could continue because the dollar's strength has broken down."

If the dollar continues to weaken, Treasury bonds are less attractive to foreign buyers unless yields widen, simply because of the added currency risk. "The U.S. dollar peaked in August," says

ABN Amro

market strategist Charles Reinhard. "It's been declining since, and it's the dominant trend, as opposed to just being fluctuation or noise."

And for all the talk of "flight-to-quality" and "haven" buying in Treasuries last year, foreign buyers were net sellers of Treasury bonds between August and December, according to the

Treasury Department

. This was the first four-month period when foreigners were net sellers of Treasuries in the past five years.

Japanese officials expect to sell bonds totaling 71 trillion yen during the next fiscal year, a 23% increase from initial budget estimates and double the amount sold in 1998.

Last week, several large Japanese insurance companies announced they would buy 1.5 trillion yen, or around $13.4 billion, in foreign securities during the next three months. Of that total, 90% will be euro purchases, leaving only 10% for Treasury purchases.

The caveat against this causing a decline in Treasuries is this: Higher yields in Japan make raising capital more cost-prohibitive for Japanese companies. A stronger yen makes exports more expensive and cheapens imports. It makes it harder for the government to finance stimulus programs. That's a positive, albeit a convoluted one, for Treasury bonds.

The way

Bankers Trust

global markets economist Josh Feinman explains it, the strong economy and stock market and the weakening currency market should have caused an increase in Treasury yields anyway. The U.S. government market would probably have done so had liquidity and sanity not disappeared in the wake of the

Long Term Capital Management

calamity last fall.

"We had a huge Treasury rally from August to October," says Feinman. "The deterioration in financial market conditions was why the

Fed

eased. Those conditions, which justifiably raised

financial market risks, have all gone in opposite directions."

So how does all this affect U.S. investors? Sentiment alone was enough to cause a selloff in Treasury bonds as a result of the announcements in Japan two weeks ago. Granted, some of this activity was a result of thin trading. But if Japanese yields continue to widen and the dollar continues to decline, long-term Treasuries will look less and less attractive when viewed in context of real inflation rates.

"Historically, changes

in the dollar either lead or happen at same time as changes in bond prices," says Reinhard. "The steepening we're seeing now is not just a one-day event."