Japan rates: Weekly review

Recent flow of funds data indicate that portfolio rebalancing activity in the private sector continues apace. From a long-term perspective, the change in fund flows should gradually push JGB yields higher. 

"We were caught off guard by this week's RMB shock, and given the risk that bonds might remain difficult to sell until the markets stabilize somewhat, we recommend taking a limited position at this point, such as JPY swaption 1m20y payers spread," notes Barclys.

The second week of August is typically bereft of news or events following the release of US payroll data, but China's RMB devaluation this week has triggered a burst of risk-off sentiment worldwide. The 10y JGB yield dropped as low as 0.355%., a level not seen since end-April. Changes on a relative value basis were typical of a risk-off market: the 10y sector outperformed on the yield curve, the superlong ASW cheapened modestly, while the 10y BEI for JGBis plunged. At the same time, there was no significant increase in the negative USD/JPY basis as would normally be expected in such a market, indicating the relative absence of carry positions.

The market implications might include:

1. USD interest rate swap receiving demand around maturities of one year through hedging of FX forward USDCNH buying demand.

2. UST buying demand through increases in foreign currency reserves if (albeit perhaps unlikely) aggressive policy measures are taken to depreciate the CNY.

3. Downside risk to inflation rates in developed economies (drop in import prices).

4. Downside risk to growth in developed economies (export decrease, import increase).

5. Financial system instability via volatile exchange rate movements and fund flows out of China.

6. A potential delay in US Fed rate hikes in response to the above developments.

Forex markets in particular this week experienced a surprisingly sharp unwinding in positions, which appeared to spark general position cuts in other markets as well. It is believed that some markets overreacted and may remain unstable for a short while, but expect all markets to return to the themes and corresponding trends that prevailed through last week. 

Looking at this week's strength in the JGB market, it appears that market positioning was biased to the short side (with long-only investors holding less than scheduled under their investment plans). 

"Last week, we forecast that yields would rise slightly within their range, but this may already have been a strong consensus view," added Barclays.