The ripple effects from Libor’s surge have traveled as far as regional Japan.
As the benchmark for U.S. borrowing costs climbs, it becomes more expensive to hedge dollar-denominated investments back into yen. That’s prompted the country’s regional banks to reduce overseas holdings to the lowest in more than three years, even as another element of their hedging costs – the cross-currency basis – moves in their favor.
The higher hedging costs, a re-ignition of bullish sentiment toward the yen and increased scrutiny from the Financial Services Agency have prompted a reassessment, according to three money managers at the lenders who asked not to be identified in discussing investment strategies.
Foreign securities, mostly bonds with some stocks, held by the lenders shrank more than 9 percent in February to 9.5 trillion yen ($89 billion), the lowest since November 2014, according to the Bank of Japan. The drop is more than double the 4 percent decline in holdings by larger banks.
The selling may continue, analysts and other fund managers said. Losses from securities holdings announced by Bank of Fukushima Ltd. this week included funds that held U.S. Treasuries, according to spokesman Takahiro Matsumoto.
“Regional banks probably cut losses before the fiscal year-end as hedged-foreign debt holdings clearly became costlier and weren’t paying off,” said Shinji Kunibe, general manager and head of fixed-income at Daiwa SB Investments Ltd. in Tokyo. “Many factors are driving up funding costs, particularly in the U.S. Selling in March may even be bigger.”
The cost for a Japanese investor to purchase U.S. securities and hedge the currency risk is a function of short-term interest rates for the dollar and yen, as well as the cross-currency basis. The basis has narrowed about 10 basis points so far this year, lowering the cost for investors to hedge.
However, Libor has soared by over 60 basis points, offsetting the benefit. The cost to hedge dollar-yen currency risk has risen from 1.90 percent to 2.46 percent in 2018, according to data compiled by Bloomberg.
While the possibility of purchasing the securities unhedged to avoid the increased costs may be tempting, Japan’s regional banks now find themselves among the Financial Services Agency’s strategic “priorities”. The regulator is urging the banks to step up risk management of foreign debt holdings to help them withstand losses in the event of a market selloff.
“The rise in volatility makes us more cautious about taking risks on interest rates,” Kenichi Kawamura, president of Bank of Yokohama Ltd., told reporters last week.
In addition, a surge in the yen to its highest since 2016 and with the key 100 level against the dollar firmly in its sights is making investors wary about taking on currency risk. The yen traded at 106.97 against the dollar as of 13:17 p.m. Tokyo time Thursday.
“Until 105 is confirmed as the dollar/yen’s bottom, it’s hard to expect dollar buying to emerge,” said Akio Kato, general manager of trading at Mitsubishi UFJ Kokusai Asset Management Co. in Tokyo. “The surge in Libor highlights hedging cost concerns and makes currency-hedged investment difficult.”
Regional banks account for about a fifth of foreign securities held by the whole banking category, the Bank of Japan data showed. Most of their holdings are in U.S. debt.
U.S. protectionism has added to upside risk for the yen and that saps the incentive to invest without currency hedging, said the money managers. Because of this, European bonds are a better alternative from a funding aspect, they said. There is also potential investment opportunities in markets where volatility is expected to rise, such as equities or equity-linked products, they added.
Whatever one’s view on risk, last year’s allocation style based around an assumption of moderate yen weakness has to be scrapped, according to Tadashi Matsukawa, head of fixed-income investment at PineBridge Investments Japan.
“Investors might have to plan based on a higher yen/weaker dollar scenario, which brings us back to the issue of hedging costs,” he said.
— With assistance by Masaki Kondo