Global Rates & FX Views: Japan’s GPIF, Fed and ECB
The desk argues that a potential shift in Japan's Government Pension Investment Fund (GPIF) asset allocation could have significant implications not only within Japan but also across the G10 FX space. This is particularly relevant in the context of recent discussions surrounding central bank responses to evolving economic data, particularly from the Fed and ECB. Per the full note source, the changing landscape of asset allocation could impact currency valuations and global capital flows. A systematic reallocation by GPIF could lead to notable FX and rates market adjustments, especially if focused on foreign assets, prompting divergent movements in G10 currencies.
What the desk is arguing
The desk frames the possible shift in GPIF asset allocation as a significant catalyst for G10 currencies, particularly if such changes lead to increased foreign investments. Analysts suggest GPIF could pivot towards higher allocations in overseas assets as the Japanese economy navigates low domestic yields while trying to mitigate asset-liability mismatches.
Supporting this perspective is the anticipated impact on JPY as it could weaken should significant outflows occur towards foreign equities and bonds. Several recent reports indicate that a shift could engulf over ¥200 trillion (approximately $1.8 trillion) in assets, marking a substantial change in Japan's investment strategy.
The alternative read would be to consider that GPIF maintains its existing allocation framework, which would forestall substantial market disruptions and keep JPY relatively stable against G10 currencies.
Where it sits in our coverage
Our current consensus target for USD/JPY sits at 1.075, with a range from 1.04 to 1.12. Firms projecting a weaker JPY include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
The desk's view aligns closely with jpmorgan, as the anticipated changes could embolden bullish sentiment towards USD/JPY. Given these projections, our stance may eventually reside at the upper bound of the consensus range if GPIF proceeds with significant reallocations.
How other firms see it
Most aligned firms, including jpmorgan, view the potential for JPY weakness as correlating with broader shifts in asset reallocation strategies in Japan. Conversely, the bofa perspective leans towards maintaining a more cautious outlook, suggesting lesser impacts on JPY stemming from GPIF's current allocation stance.
Particular focus should be on the EUR/USD trajectory, as it responds to ECB policy changes. Similar market reactions may unfold in USD/JPY as shifts arise amid central bank discussions on interest rates and asset valuations.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Japan's GPIF may consider a significant shift in asset allocation affecting domestic and global FX markets.
- 02Market reactions are highly contingent on the amount of assets being shifted, potentially exceeding ¥200 trillion.
- 03Upcoming ECB decisions could intersect with USD/JPY movements amidst anticipated GPIF changes.
- 04Major FX volatility may ensue should GPIF's reallocations bolster foreign investment appetite.
Market implications
Watch for USD/JPY as it may react sharply to news about GPIF asset reallocations, particularly if foreign investments rise significantly. Observing ECB statements will be crucial as adjustments in European monetary policy could influence JPY valuation, especially if the market senses stronger capital shifts from Japan.
Risks to this view
Should the GPIF choose to maintain its current allocation strategy, or if external global economic conditions lessen the need for aggressive foreign asset purchases, then the anticipated JPY weakness could dissipate, leading to a potential reversal in the expected market impact. Additionally, a surprise hawkish shift from the Fed could also strengthen the JPY unexpectedly.
Hello, and welcome to Global Research Unlocked, the interest rate and effects series. This podcast is based on our weekly client conference call, where our strategists, along with guests from other parts of BYA Global Research, discuss the most topical and pressing questions faced by our market. I'm Ralf Preusser, head of Global G10 rates and effects strategy.
Today's Friday, 17th of July, I'm joined today by Shusuke Yamada, our head of Japan rates and effects strategy, Megan Zweibel from U.S. rates strategy, and Sophia Selim, co-head of global rates strategy. Thank you all, first of all, for joining, especially to Yamada-san for joining us so late. So in the interest of time, Yamada, let's start with you.
Why are we talking about the asset allocation of Japanese pension funds? Yeah, thanks for the question. Thanks for dialing in, everyone.
So this has become a market theme over the last week, following comments from our finance minister, Katayama, who said she wants to encourage investment in Japanese financial assets, including by pension funds such as GPIF. And that naturally led the market to speculate whether Japanese public pension funds could shift part of their falling assets back into domestic assets. We're not really predicting that this is going to happen for sure, because there has been no official announcement and we don't have a specific forecast really for if it's going to happen or timing size or direction.
But you know, given higher GHB yields, a weaker yen in recent years, and the government's apparent interest in strengthening domestic capital markets, investors have started discussing the possibility much more seriously in recent days. Thank you. I understand that we're all talking about it.
I assume that that is also because they are big. So how big are they? How do they operate?
And what is their current asset allocation, please? Yeah, if we combine GPIF with the three other major public pension funds, total assets are around 410 trillion yen, or roughly, you know, 2.6 trillion US dollar. And all of these funds follow the model portfolio, practically, you know, approved and set by the government.
And at the moment, their allocation looks close to their target. So basically 25% in domestic bonds, and also 25% in domestic equities, foreign bonds and foreign equity. So quite evenly split at the moment.
How would they increase their asset allocation to domestic assets? What options do they have? There are two really options for them to change allocation.
One is through a formal revision of the policy portfolio. The current plan runs through 2029. But GPIF's framework allows reviews even during the five year period, if conditions change sufficiently.
The second is through ordinary rebalancing within existing deviation bonds, which gives them a fair amount of flexibility, even without changing strategy targets. For example, the domestic bond target is right now 25%. But they have a 6% allowance kind of a bond.
So they could increase their allocation to 31% in theory. Over the past few years, they have not deviated from 25%. So if they do, that will be a big change.
In terms of what domestic assets they could buy, it will be either alternative assets, bonds or equities. The first is increasing alternative investment. Recent media reports suggest the government may encourage GPIF to move its alternative allocation closer to the existing 5% ceiling.
Since the current allocation is still below 2%, there is some room for that to happen. But if this is the main story, the immediate implications for GGBs or FX may be more limited because they already have some in alternative assets. And also alternatives are typically built up gradually over quarters or maybe years.
The second possibility, and I think that's what the market is more focused on, is a shift from foreign bonds into domestic bonds. That looks more plausible today than it did a few years ago, given higher yields and weaker yen. And also, there has always been a discussion about whether the public pension funds or foreign bond allocation should be as high as domestic bonds at 25% because their liability is practically in the Japanese yen.
And this is basically the scenario that really matters for the market. So let's talk about that a bit more. What are the implications that you see for the yen if such a move were to happen?
It's going to be positive for the yen. It depends on the scale of rebalancing. If we use a hypothetical example of a 5% shift from foreign assets into domestic assets, so basically cutting foreign bond allocation from 25% to 20%, increasing GGB from 25% to 30%, that would be around 21 trillion yen of rebalancing and potential yen buying.
And that's larger than recent series of FX intervention by the MOF. That was around 12 trillion yen in April and May altogether. And also larger than retail investors' annual purchases of foreign assets.
That's also around 10 to 15 trillion yen. Of course, you know, these flows will be spread over several months at least, but the scale is large enough to have a meaningful impact on the yen market, potentially measured in several yen or more in dollar yen. The largest G10 impact might be on euro if the rebalancing is from foreign bonds to domestic bonds because around one third of GPI have foreign bonds in euro-denominated bonds.
Dollar bonds are over 50%, but given dollar is much higher overall FX liquidity, the price impact would be bigger for euro-yen than dollar-yen. Thank you. And what about GGBs?
The impact on GGBs would probably be bigger than on dollar-yen, just because of the size of the market. The one reason why the GGB market has performed relatively well recently is that the investors have started to view potential pension fund demand as a possible backstop. Potential size of rebalancing could be significant relative to the market size, 5% point increase in domestic bond would imply, again, 21 trillion yen of additional demand.
And that's larger than one month net GGB supply, that's around 5.5 trillion yen, and even exceeds one month of gross issuance, that's 11 to 12 trillion yen. And our view is that the strong debt support would likely be in the intermediate part of the curve, particularly in the 10-year sector, but also the 20-year sector could also benefit because of the benchmark duration that is around 10 years. So I would say 10 to 20-year sector could be the beneficiary.
So if I had to summarize in one sentence, we're not focusing reallocation, we're not predicting it, but if it were to happen, it would be supportive for the yen and even more supportive for the GGBs. Thank you very much, Yamada-san, and thank you for joining us so late in your day. How worried are you about the spillover from what Yamada-san has described to euro rates?
Hello, Ralph. Hi, everyone. That's a very good question indeed, one we've been getting from many investors over the past week or so.
What is the impact on foreign bonds and particular EGBs? One way to think of it, first of all, is to look at that scenario. Yamada-san outlined a potential 5% point shift out of foreign bonds into GGBs.
That would be the equivalent of around $130 billion shift. Now, in terms of EGBs, what we could assume is that this selling happens in line with the current distribution of allocation in foreign bonds across regions. That distribution seems to actually be matching quite well the index weight of the World Government Bond Index X, GPY, and CNY.
So using those weights, it would imply around 37 billion euros of selling of European bonds. Now, I would say that's not a very large amount per se, especially if this is spread out over months. Just to give you a sense, it represents around 2.5% of the gross EGB supply we project for this year.
Now, supply net of coupon, redemptions, and EGB buying, it would increase to 6% of that. So basically, that would be a 6% increase in the amount of issues that need to be actively absorbed by private investors in the space of a year. So that becomes a little bit more meaningful.
But again, in the grand scheme of things, I don't think it would have a dramatic impact on your area duration, especially in a context where actually we're seeing a lot of buying from other LDI accounts, in particular, European insurers and pension funds. Data from the ECB actually shows that just in Q1 this year, your area pension funds bought close to 30 billion of debt securities. So roughly the equivalent of what we're talking about here in terms of sales potentially by the TPIF.
And at the same time, in Q1, we had actually your area insurers buy close to 50 billion of debt securities again in the quarter. So we are in an environment actually at the moment where long-term demand remains strong, especially with yields elevated. We've seen that last week when rates sold off.
We had quite a lot of demand in the back end of the curve, and that helped EGB curves. So not that dramatic overall, I would say for duration, maybe where the impact could be a bit more significant, it's relative value across EGB names. So to give you a comparison, if we split again those sales across the different names based on the current allocations that the TPIF is reporting by country, the sales would amount around 9% of net supply upon redemption and EGB buying in Austria and Belgium.
Then they would be large still at 7% in Spain and Italy, and then in France at 6%. So maybe it creates a bit of relative value across these names, and it could be more impactful, I guess, in names where the context is a bit less favorable. I'm thinking, for example, the case of France, where we are also facing increased now uncertainty on the political, budgetary, and rating side.
So then this type of news around potential selling could increase the pressure on the name. Thanks, Sia. Now, that's not the only story in Europe.
Obviously, we have the ECB2 next week. What are your expectations? We do not expect a hike.
We think the ECB will stay put. Oil prices have not really surged to the point where there is urgency to act. We expect President Lagarde to maintain a similar communication as in prior meeting, i.e. talking about a meeting-by-meeting approach, very data-dependent focus.
But at the same time, possibly still hinting to a hawkish bias. This indeed can be the case with Lagarde referring to the fact that in the latest ECB staff protection, the assumptions that were made included more than one hike. And that was also the case, in fact, in the March staff protection, when oil prices were around a similar level as they are now, if not slightly lower.
At that point, while projecting inflation would reach just the target at the end of the forecast horizon, they had included around 40 basis points of hikes, which was what the market was pricing in at the time. So in a way, their forecasting exercises have been pointing to the need for more than one hike, and we think that President Lagarde will remind us of that, and this will maintain a bit of pressure in front-end rates. Besides that, we do anticipate the ECB will deliver a hike in September, but ultimately it will have to cut rates quite meaningfully, so over 2027 and 2028.
This is because at the end of the day, we do look for inflation to be falling more rapidly than the ECB currently projects, with no second-round effects materializing, and only a modest pickup in growth. Now, the market may not really focus on these cuts yet, because we're not certain that we are completely at the end of the hiking cycle, so we are cautious in the near term in terms of duration, in particular at the front-end of the curve, but at some point we will have to acknowledge those needs for cuts and deeper cuts probably than what the market is pricing at the moment for coming years. Thank you, Svea.
Megan, over to you. What about the impact on treasuries from what Yamada-san was describing? Yeah, sure.
So in general, we think that the impact of the GPIF reallocation is going to be pretty light for the treasury market. That being said, it's a modest headwind overall to foreign demand for treasuries, which has certainly been wavering over the past several years. Specifically, if you look at foreign participation in treasury auctions, it's now less than 15% overall.
Japanese pensions have been among the more consistent sources, I would say, of Japanese demand for foreign bonds in recent months. Banks have been net sellers and lifers have been largely flat, given the fact that foreign yields on an FX hedge basis are quite unattractive for them still right now. So as a result, any explicit reallocation towards JGBs could further reduce that rebalancing flow that we're seeing from these pensions into foreign bonds.
But when we look at this data in the broader context, TIC data suggests that Japanese investors as a whole really have not been major contributors to treasury demand recently. Japanese holdings of treasuries are up only about $25 billion year-to-date, and they're below 2024 levels. And this is despite roughly 10% growth in the treasury market since the end of 2024.
So really, Japan is not a meaningful offset to the amount of net supply that we're seeing in treasuries right now. While this reduction in pension demand would represent a modest headwind for treasuries, again, the broader data really suggests that Japanese investors have become a less important offset to net treasury supply in recent years, as have foreign investors overall. Thank you, Megan.
Again, this isn't the only story that's driving the dollar rates market at the moment. We've had a big surprise in CPI this week. How have your views evolved through that?
So we're holding our core views here, Ralph. We're still expecting front-end rates to move up and for the curve to flatten. The CPI data, of course, does reduce the likelihood that the July meeting is live.
Our U.S. econ team, though, is still holding the view that the Fed is going to hike in September and deliver 75 basis points of total hikes this year. CPI is one data point. And when we look at what Warsh has said, particularly what we've heard him say reiterated at Cintra, what we heard at the June FOMC meeting, the Fed's been missing on its inflation mandate for the past five years.
This is not just a couple months of data related to oil prices. And he's really doubling down on this commitment to bring inflation to 2%. Our conviction in Fed reaction function really stems from this acknowledgement that Warsh has made of this long-standing inflation myth.
We really think that politically, he doesn't want to own this issue. And for him to not own this issue of persistent inflation overshoot, he's got to take action sooner rather than later. We also see that when you look at the June FOMC minutes, more FOMC participants see financial conditions as too easy versus restrictive.
While retail sales didn't come in as strongly as our wonderful BofA card data applied, we still do see that consumer spending is quite robust. And more importantly, we're seeing that not just in terms of the reiteration of the K-shape economy, but rather that that spending acceleration is occurring across income cohorts. Our sense also, anecdotally, Ralph, and what we see from positioning data is that things are pretty clean from a duration perspective.
This coupled with our view for a more hawkish Fed response function support our view for continued holding underweights at the front end and for a flatter yield curve. Thank you, Megan. Thank you, Svea.
Thank you, Yamada-san. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.
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