I am the one who knocks

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Heroin Addicts

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It was just a few days ago when we showed you how, once you take into account FX hedging, buying US government debt is actually not as good of an idea as it seems if you’re a Japanese investor buying safes and stashing cash to escape negative yields.

As it turns out, the global USD crunch has eliminated the yield pickup, jeopardizing the bid for US government paper (if not US corporate paper) and putting yet another wrinkle in the warped financial universe space-time continuum.

Well, on Tuesday, Citi is out with some new commentary on this very same subject that we’ve been discussing for months. Here’s an excerpt:

“We think recent non-US Central Bank actions, actual and anticipated, are playing a role. In Japan, the BoJ’s “comprehensive assessment” of monetary policy due 21 September is likely to try to reduce (so called) excess flattening of the yield curve. We assume the only reason the BoJ wants a steeper curve, where the Fed and Operation Twist once wanted a flatter one, is that they think this will help banks’ profitability, offsetting the impact of NIRP (perhaps it will also help insurance companies’ carry). But to achieve a steeper curve probably relies on buying fewer (or even selling) long dated bonds. This either implies tapering of QE – likely to provoke a tightening overall of FCIs – or that buying at the short end becomes even bigger, driving front end yields ever more negative. As this occurs, the incentive for Japanese investors to buy foreign bonds like USTs would fall even more (because FX hedging costs would rise and long end spreads fall) relative to extending duration locally. As we have shown before, recent market movements already leave Japanese investors unlikely to choose FX hedged USTs over longer duration JGBs. Note how closely the JGB curve steepening recently has been correlated with 10y USTs. Actually the JGB curve turned up slightly before UST yields but it’s effectively the same trade. Similarly, the inaction at the 8 September ECB meeting has generated a steepening in the EA core bond yield curve. Again, higher yields and an increased FX hedging cost make for a reduced incentive to buy FX hedged Treasuries out of core Europe.”

hedge

(Charts: Citi)

So you can see what’s happening here, right? Driving investors out the curve and down the risk ladder. The thing is, they have to maintain this. There’s too much money betting on it. If they (central banks) pull it now, it’ll be like a heroin addict going through withdrawals.

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