The risk of a "big return" of Japanese capital is rising! Japanese bond yields are approaching 30-year highs, and over a trillion dollars in U.S. Treasury holdings are under scrutiny.

As Japan's government bond yields rise to their highest level in nearly 30 years, a risk that has long been discussed in global markets is being reevaluated: whether Japan's massive overseas funds will begin flowing back to domestic markets. Although there are currently no indications of a large-scale withdrawal from overseas assets, some investment institutions warn that as the attractiveness of Japanese government bond yields continues to grow, the market may be underestimating the speed at which Japan's capital flows could change, as well as the potential impact of this change on the yen, U.S. Treasuries, and even the global financing environment. Japan has long maintained an ultra-low interest rate policy, forcing domestic investors to seek higher returns abroad, thereby becoming one of the world's most significant capital-exporting countries. Currently, Japanese investors hold nearly $5 trillion in overseas assets, and Japan remains the largest foreign holder of U.S. Treasuries, with holdings of about $1.1 trillion. However, this long-established investment logic is undergoing a shift. Last week, Japan's 10-year government bond yield briefly touched 3%, reaching this level for the first time since 1996. Inflation pressures, government fiscal spending prospects, and market expectations that the Bank of Japan may accelerate interest rate hikes have all driven Japanese government bond yields higher. Meanwhile, since September, the yen has appreciated about 4%, becoming the best-performing currency among the G10 currencies. Whether the Government Pension Investment Fund (GPIF) will increase its allocation to Japanese domestic bonds has also become a focal point for the market. Kenichiro Ueno, Japan's Minister of Health, Labor and Welfare, who oversees the GPIF, stated on Tuesday that the fund is still studying whether there is a need to reconsider its current asset allocation. Ales Koutny, head of international rates at Vanguard Asset Management's active funds, noted that if Japan's domestic yields continue to rise, Japan may gradually retain more capital in the country, which not only concerns the yen and Japanese government bonds but could also impact U.S. Treasuries, European bonds, and the broader global financing environment. The market is particularly focused on whether the GPIF will become a potential catalyst for the capital inflow. If the GPIF increases its allocation to Japanese domestic bonds and prompts other pension funds, insurance institutions, and individual investors to take similar actions, the scale of capital returning to Japan could be quite substantial. Deutsche Bank previously estimated that in a scenario where pension funds, insurance companies, and individual investors broadly adjust their asset allocations, the potential scale of funds flowing into Japanese domestic assets over the coming years could reach as high as $440 billion. Ashwin Binwani, founder of the private investment firm Alpha Binwani Capital, believes that the market is still underestimating the possibility of a "massive capital return" from Japan. It is worth noting that Japan does not need to sell off a significant amount of its existing U.S. Treasuries and other overseas assets for it to impact global markets. As long as Japanese investors allocate less new capital to overseas investments in the future, this could weaken an important force that has long supported global bond demand, thereby putting upward pressure on long-term borrowing costs in the U.S. and other economies. From a yield perspective, the competitiveness of Japanese government bonds for domestic investors has clearly increased. With dollar hedging costs currently close to 3%, the yield on 10-year U.S. Treasuries, after accounting for currency risk hedging, is about 2% when measured in yen, which is roughly 1 percentage point lower than that of Japanese government bonds of the same duration. In other words, for Japanese investors needing to hedge against currency fluctuations, Japanese 10-year government bonds currently offer higher real returns, a stark contrast to the environment in which Japanese capital surged into overseas bond markets over the past few decades. However, at least from the current actual capital flows, the so-called "massive return of Japanese capital" has not yet truly materialized. Shoki Omori, chief strategist for Japan fixed income at Deutsche Bank, stated that as of August this year, Japanese life insurance companies have not significantly sold foreign bonds, banks have only made modest reductions, and pension trust funds are still continuing to increase their overseas assets. The strategy currently adopted by Japanese investors is more about reducing currency hedging rather than directly withdrawing capital from overseas. Omori estimates that the proportion of currency hedging for new overseas bond investments has fallen from 62% in 2024 to about 40% this year. As existing hedging positions expire, an increasing amount of new overseas investments is choosing not to hedge against currency risk. This also means that whether overseas bonds remain attractive to Japanese investors in the future will increasingly depend on the yen's performance. If the yen continues to appreciate, the incentives for capital to flow back to Japan may further strengthen. As more Japanese investors hold overseas bonds without currency hedging, a stronger yen will directly erode the investment returns of these assets when converted back to yen, while also diminishing the attractiveness of arbitrage transactions that finance high-yield overseas assets with low-cost yen funding. Following the yen's critical level of 155 yen to 1 U.S. dollar, some analysts expect the yen's appreciation could accelerate further. If the Bank of Japan continues to tighten monetary policy and the interest rate differential between Japan and the U.S. narrows, the necessity for Japanese investors to allocate large amounts of funds to overseas markets may also diminish. However, there remains a significant divide on Wall Street regarding whether a capital return is imminent. Stephen Spratt, a strategist at Industrial Bank of France, remarked that the risk of Japanese capital returning does exist, but it is still unclear which types of investors will be the first to withdraw large amounts of overseas funds. Some analysts believe that the factors preventing Japanese institutions from increasing allocations to domestic bonds are no longer that yields are not high enough, but rather that investors have not yet been convinced that Japanese government bond yields are close to their peak. Masayuki Nakajima, a senior strategist at Mizuho Bank, stated that from both a historical perspective and an asset-liability management standpoint, a 3% yield on 10-year Japanese government bonds is quite attractive. However, given the uncertainty around inflation, fiscal policy, and how much further Japanese government bond yields can rise, large institutions remain hesitant to increase their long positions in long-term bonds too early. He pointed out that compared to the absolute yield levels, the stability of yields is more important. Once investors believe that Japanese government bond yields have stabilized, the same 3% yield level may attract significantly stronger buying interest than currently observed. James Athey, a fund manager at Marlborough Investment Management, believes that the conditions needed for a capital return from Japan are actually already largely in place. With rising domestic bond yields, a narrowing interest rate differential between Japan and the U.S., increased expectations of further rate hikes by the Bank of Japan, and the yen beginning to appreciate, the economic impetus for Japanese investors to reallocate their assets is steadily strengthening. Athey noted that given the attractiveness of Japanese domestic bonds relative to overseas bonds at present, he is surprised that more Japanese institutions have not yet shifted their bond investments back domestically.