Why the Japanese see an opportunity in U.S. bonds

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The Japanese have experience with debilitating deflation. Some of them apparently are convinced the U.S. is heading down the same path.

Japanese investors’ purchases of foreign bonds hit record levels in June and July, a rush of money that Wall Street traders say has helped to drive market yields on U.S. Treasury securities down sharply since spring.

If you expect deflation rather than inflation, locking in yields on government debt is considered a sure-fire investment strategy -- because interest rates on high-quality bonds are likely to keep falling. That’s what the Japanese learned with their own bonds in the late-1990s and again in the last few years.

Robust Japanese demand for foreign bonds this summer has coincided with an intensifying debate on Wall Street over the likelihood of the U.S. falling into a deflationary cycle, meaning a broad-based, sustained decline in prices of many goods and services.

U.S. core inflation -- prices for everything except food and energy -- was up 0.9% year-over-year in June, the slowest pace of increase in 44 years, government data show.

That’s skating too close for the comfort of some Federal Reserve officials, including James Bullard, head of the Federal Reserve Bank of St. Louis. Central bank policymakers hold their mid-summer meeting on Tuesday and are expected to mull whether to take new steps to bolster the economic recovery.

Japan has demonstrated how low government bond yields can go when deflation fears take hold and investors focus on safety above all else.

In 1990, just as Japan’s debt-fueled real estate bubble was bursting, the annualized yield on 10-year Japanese government bonds was 6.53%. By the end of 1993 the yield had fallen to 3.33%. And by 1999, just before Japan slipped into its sustained deflation of the early-2000s, the yield was at 1.68%.

By mid-2003 the yield had plunged as low as 0.45%. It rebounded to nearly 2% with the global economic boom of the late-2000s, but now is back down to 1.03% (see chart, above).

So with the U.S. 10-year Treasury note yield at 2.82% on Monday, by Japanese standards that still looks like a great return to lock in -- and particularly if you think bonds will only be paying less a year from now.

“The Japanese have been big buyers” of Treasuries, said Dan Greenhaus, chief economic strategist at investment firm Miller, Tabak & Co. in New York. “They’re betting on us becoming them.”

If U.S. deflation worries ebb and bond yields rebound the bet will go bad, at least insofar as the market value of existing fixed-rate bonds will drop.

The Japanese also face another risk: If the dollar slides further against the yen, U.S. securities will decline in value when translated from dollars to yen. That already has been an issue this summer. The dollar has dropped to less than 86 yen in recent days, a 15-year low and down from 95 yen in early April.

But currency risk can be hedged. In any case, the strong yen clearly wasn’t a deterrent to Japanese investors who’ve been pouring into foreign bonds the last two months.

-- Tom Petruno