The bad times are back for U.S. bonds, and it’s not just a matter of inflation fears combining with fiscal profligacy. There is a third source of pain from an outside source: Japan. 

Japanese holders of Treasuries are having a rough time, getting hit by a double whammy of rising yields and a persistently weak dollar. And it looks like from the recent flow of funds data they’ve had enough -- their 866 billion yen ($8 billion) of sales last week was the first net weekly sale this calendar year. Confirmation of the trend may come on Friday, when the Ministry of Finance publishes the latest data.  

Japan’s financial year-end is March 31, and that’s typically a time to reduce exposure and cut losing trades. That is piling on the trouble for Treasuries.

The start of April typically involves a new round of buying, and with only ultra-low yields available in Japan there is still a strong temptation to look abroad for a half-decent return. While the most popular destination has traditionally been American debt, 2018 probably won’t see much Japanese money return to the U.S. 

What’s changed is the dollar. Japanese investors have tended not to hedge their Treasury holdings, because the cost of stripping out the currency risk of dollar exposure has risen along with the Federal Reserve’s move into a hiking cycle. The rolling three-month cost of hedging a dollar asset back into yen has soared from a 25 basis point floor three years ago to over 220 basis points now. 

For yen-based investors that leaves the net currency-hedged return on U.S. 10-year notes at only 60 basis points. As the yield on 20-year Japanese government bonds is similar it is hardly worth the effort investing abroad -- unless you take the currency risk.

That worked fine for a while. But the recent weakness of the dollar has taken away all of the return on U.S. Treasuries, and now Japanese holders face outright losses. 

In comparison, due to negative European Central Bank rates, a net currency-hedged return on 10-year French government bonds is about 1.2 percent, double that of staying at home in 20-year JGBs. So it is more compelling for Japanese investors to hold European bonds currency-hedged than dollar bonds either hedged or naked. 

Once the new financial year starts in April, Japanese buyers could well start piling in to European debt. U.S. bonds will probably get left out in the cold. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

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