Foreign investment honeymoon period comes to an end! Institutions accelerate withdrawal from Japanese government bonds, "BOJ slow hawkish + ultra-easy fiscal policy" triggers confidence crisis.

After a brief capital inflow, top global bond fund managers are once again fleeing the Japanese government bond (JGB) market at an astonishing pace. Despite the Bank of Japan expected to announce a rate hike at its monetary policy meeting on Tuesday (June 16), and JGB yields climbing to their highest levels in decades, this has not been enough to retain the pace of smart money from overseas. The latest official data shows that in April, overseas investors sold more ultra-long-term JGBs than they bought, marking the first net outflow since 2024. Wall Street analysts point out that the essence of this retreat is not a valuation issue, but a "trust crisis." Foreign investors are generally concerned that the Bank of Japan's actions are too slow in the face of the current severe imported inflation and are highly vulnerable to compromising with political pressure from the new administration of Prime Minister Kan Naoto, leading Japan into a vicious cycle of expanding fiscal deficits and currency devaluation. Wall Street giants collectively slashing positions: from "buying on dips" to "cutting losses decisively" A year ago, when the Bank of Japan gradually exited its ultra-loose policy, overseas capital once cheered for the return of the "high-yield JGBs." However, just over a year later, many traditional fixed income giants including T. Rowe Price, Schroders Global Investments, and Brandywine Global have begun to significantly reduce or liquidate their holdings of long-term JGBs. "Given the enormous negative real interest rate environment in Japan, we believe the Bank of Japan's responses have lagged somewhat," said Carol Lye, portfolio manager and senior research analyst at Brandywine. The company recently reduced its holdings of Japanese government bonds and sold its positions in 30-year JGBs, reallocating some funds to British government bonds. She pointed out that while there have been improvements in the valuation of Japanese bonds, "the structural supply and demand dynamics remain complex." This shift poses a challenge to Japanese policymakers. The ultra-loose monetary policy over the years was supposed to attract higher yields to lure foreign capital back into the Japanese bond market. However, many investors argue that confidence, not valuation, has become the biggest obstacle to holding the longest-term Japanese bonds. This hesitation comes at a delicate time, as the Bank of Japan gradually reduces its interventions in the market, and traditional domestic buyers have yet to return strongly. Vincent Chung, portfolio manager at T. Rowe Price, has been underweight Japanese government bonds for the past year. He bought in January this year, but reduced his holdings a month later as fiscal concerns worsened. "This trade is facing some unfavorable factors, such as expanding fiscal spending, changes in long-term demand, and the continued reduction of the Bank of Japan's balance sheet," he said. Fatal schism: Kan Naoto's "loose expansion" clashes with the Bank's normalization path The key catalyst for overseas investors choosing to "cut their losses and run" comes from the macro policy direction of the current Prime Minister Kan Naoto's administration. Known for advocating loose monetary policies, Kan Naoto has vigorously pursued an expansionary fiscal policy since taking office, repeatedly calling for a massive supplementary budget to alleviate the impact of rising prices on households. This "extreme fiscal expansion, forced monetary tightening" policy inconsistency has exacerbated anxiety over inflation caused by rising oil prices and the pace of policy normalization. Secondly, the government's supplementary budget and repeated calls to take measures to alleviate the impact of rising prices on households also amplify concerns about the inconsistency of fiscal and monetary policy directions. Kan Naoto is known as an advocate of loose monetary policy. Shinichiro Arie, co-head of fixed income at Amundi Japan, admits that he still maintains an underweight stance on Japanese government bonds: "The key is that the government must stop intervening in monetary policy. If the global market thinks that the Kan administration is pressuring the Bank of Japan, concerns about the delayed response and lagging actions of the Bank of Japan will evolve into systemic panic." Tempting arbitrage trades On the surface, Japanese government bond trading seems attractive. For US dollar-denominated investors, hedging currency risk can bring returns comparable to, or even higher than, the US Treasury market in some maturities. Currently, after hedging, the implied yield of 30-year JGBs exceeds 6%, about 170 basis points higher than the equivalent US Treasury bonds. However, the tempting arbitrage returns have not been able to effectively withstand market volatility. Long-term JGB liquidity has always been poor and highly vulnerable to fluctuations in supply and demand and fiscal policy. Since the beginning of this year, due to market turbulence, the yield of 30-year JGBs has risen by over 40 basis points, with the root of the market volatility being concerns that the Kan administration may further increase fiscal spending causing many investors to suffer losses in their mark-to-market valuations. Lei Zhu, head of fixed income at Fidelity International Asia, says that volatility remains a major constraint in building large positions in long-term JGBs. "We still like longer-dated government bonds, especially bonds with three to five-year maturities, because the policy transparency at this tenor is relatively high, and the balance between yield compensation and volatility risk is more balanced." The continued weakening of the yen once again underscores investors' lack of confidence in Japan's policy mix. Typically, the rise in JGB yields would support the yen through narrowing interest rate differentials and enhancing the attractiveness of domestic assets. However, the yen has weakened against the trend, ignoring the Bank of Japan's gradual rate hikes and swallowing Tokyo's record currency interventions, while the macroeconomic gap between Japan and the US remains difficult to bridge. Squeezed shorts and the yen paradox: Who will act as the "last buyer"? This growing sense of skepticism is becoming increasingly evident in market positioning. Bank of America Securities points out that the view of having a short average duration of the yen exchange rate has become one of the most crowded trades in the market. The bank stated that as many investors expect policymakers to gradually implement policy normalization, expectations of a weakening yen continue to strengthen especially reflected in the long positions of the US dollar against the yen. The issue goes beyond the positioning of foreign investors. With the Bank of Japan reducing its bond purchase sizes and gradually diminishing its market influence, policymakers are increasingly relying on demand from the private sector to absorb government debt. However, despite rising domestic yields, there is little sign of life insurance companies and pension funds repatriating foreign assets, which raises questions about who will absorb the continuously growing supply of bonds. Nevertheless, not everyone is pessimistic. Mark Dowding, Chief Investment Officer of Fixed Income at RBC BlueBay Asset Management, said that a yield of over 4% on 30-year bonds looks attractive, prompting the company to adopt a long-term bond investment strategy. "If the Bank of Japan takes the right steps, if they raise rates this month, and announce plans to continue with monetary policy normalization later this year, I believe the long-term bond market can continue to improve from oversold levels." Despite some optimism, the overall market remains extremely unwilling to chase higher yields. James Ringer, portfolio manager on the fixed income investments team at Schroders Global Investments, noted that the company primarily focuses on yield curve trades rather than directly holding Japanese government bonds. He also added that they need to see signals from the Bank of Japan for further tightening of monetary policy before adopting a more bullish stance. "Without this, we believe long-term Japanese government bonds are unlikely to maintain any meaningful excess returns," he said.