Our sense is that Japanese investors are unlikely to return as significant buyers of major global bond markets in the 2022/23 Japanese financial year. Ministry of Finance [MoF] data show Japanese investors had their largest ever net selling of foreign bonds in 2021/22. If our view that the global bond sell-off accelerates is correct, by extension Japanese investor selling is likely to intensify as well.

Japanese selling of foreign bonds is likely to slow and reverse when investors anticipate central banks are approaching terminal rates. With estimates for terminal rates shifting higher, however, the timing of a reversal is likely further in the future.

MoF data show Japanese investors were net buyers of Australian rates products in Q1 2022. In fact, 2022 set a record for Q1 purchases based on MoF historical data. I suspect this will surprise most readers.

There are a few conclusions to draw from this. First, it tells us Japanese accounts did not primarily drive the underperformance in Australian rates versus offshore – it was driven more by ex-Japan selling and lower liquidity.

Second, we gained valuable insights into the composition of Japanese net buying. We saw significant selling of SSA paper from Japanese accounts as Australian dollar-yen spiked in Q1. The only way, therefore, that Japanese investors could have been net buyers of Australian products was if they were purchasing Australian Commonwealth government bonds (ACGBs) and semi-government paper.

Logically, Japanese selling has had the most pronounced impact on the SSA market. Regional and global accounts absorbed the outsized Japanese SSA selling in March and April, at very attractive margins. But these accounts are not emerging as buyers of new issuance at lower spread levels and Japanese accounts are showing limited appetite to buy.

Consequently, primary market volume is down and could remain low unless SSA pricing becomes more attractive versus other rates product. Upcoming redemptions should support SSA volume in the near term, however.

At the ACGB and semi-government level, it is unlikely other foreign investors will jump in quickly to fill a potential future vacuum left by Japanese accounts. Our client conversations suggest market participants had ‘trust issues’ about Reserve Bank of Australia (RBA) policy guidance and this is limiting investor appetite.

We do not think these issues are as pressing now as the central bank is no longer dovish. But the prospect of the RBA turning more hawkish and for other central banks to follow suit means global bonds could be met with a buyers’ strike, driving yields higher before value-driven buying of Australian bonds emerges from offshore.

European accounts are not pulling the trigger to buy right now, but we have noted a pickup in enquires. Meanwhile, we expect domestic bank balance sheets to take advantage of opportunities to buy to meet regulatory requirements.

As for SSAs, the experience from March and April illustrates regional and global accounts will step in and take advantage of relative-value opportunities and dislocations in the sector.

Heightened uncertainty about global inflation and central banks’ response provides very little incentive for investors to take on duration risk. But issuers are indifferent between the three- and five-year points, so supply will meet demand.

Domestic and global accounts are clearly noting their preference for three-year tenor. Further out, there is demand for 10 years from Japanese accounts but it is nowhere near historical volume. In addition, Japanese interest in the 15-year segment has all but disappeared.

We expect liquidity to be scaled back on further fiscal and monetary tightening. Indeed, we have already seen this. Bid-offer depth is narrower, the cost to trade is increasing and deviations from fair value are widening. This is not something specific to rates markets – it is evident across asset classes.

The major risk for markets revolves closely around the US Federal Reserve’s actions to begin removing significant stimulus via quantitative tightening. We believe the risks are skewed toward a further tightening in liquidity over the course of this year.

Aside from gappy price action, we expect higher yields and wider swap spreads to weigh on AUD SSA paper in the secondary market – in turn driving higher new-issue concessions.

We expect the impact of these factors to be lesser for the Kauri market. The size of the New Zealand banks’ funding task to repay the funding for lending facility is less onerous compared with Australian banks repaying the term-funding facility (TFF). Australian dollar bank spreads are therefore more prone to widening as liquidity is scaled back – in turn, driving Kangaroo spreads wider.

The investor base for Kauris is also smaller, more stable and more concentrated toward New Zealand balance sheets.

The bulk of the investor base has historically assessed Kangaroo bond relative value versus ACGBs and semis. We expect this to remain the case for domestic investors and most official institutional investors in Australian dollars. This is particularly so with SSAs trading at wide levels that have historically coincided with demand and outperformance.

For example, five-year SSA Kangaroos trading 35 basis points above semi-governments should draw interest. However, bank treasuries, some official accounts and non-Australian dollar funded Japanese investors are likely to continue assessing Kangaroos against global SSA issuer curves as these accounts factor in hedging costs.

The RBA has lagged its global peers on policy tightening, yet Australian rates have underperformed on a cross-market basis. The underperformance of Australian rates suggests the market is rewarding bond markets where central banks are perceived as adopting a credible and proactive approach to tightening monetary policy.

While inflation may be more advanced offshore than it is in Australia, the RBA’s stance on inflation has clearly turned more hawkish. The risk for the RBA is a wage spiral that spurs even higher inflation.

There was a noticeable revision to the December 2022 forecast for underlying inflation in the RBA’s May statement – to 4.75 per cent year-on-year from 2.75 per cent in the February statement. We believe it is highly likely the RBA will revise this higher again in August.

As such, we do not assign high odds to a materially lower cash rate in Australia than offshore. A higher cash rate should see higher Australian dollar yields versus offshore, wider swap spreads, higher Australian dollar funding costs and a wider cross-currency basis.

If we are wrong on the RBA cash rate and it is indeed materially lower than its peers, the only conceivable reason is either inflation surprising to the downside in Australia or inflation surprising significantly to the upside offshore, or both. In this instance, ACGBs should outperform cross-market.

However, with regulatory high-quality liquid asset buying and TFF pre-funding a binding constraint regardless of the cash-rate outlook, swap spreads and the cross-currency basis should be wider – just not as wide as under a higher RBA cash rate scenario.

FTSE Russell’s announcement is a positive development for the NZGB market. Although NZGBs will account for only around 0.2 per cent of the WGBI, inclusion should draw passive buying of around US$5.7 billion.

This development comes at an opportune time. A broader investor base will not only be supportive for future NZGB syndications – NZGBs are the highest-yielding double- or triple-A bond in the index – but index buying will more than absorb the Reserve Bank of New Zealand’s NZ$5 billion (US$3.3 billion) annual sell down of its QE portfolio.

The announcement is unlikely to have any material impact on Kauri SSAs as these bonds are not included in the index and roughly 90 per cent of Kauri investors are locals.