Japan's 40-year government bond auction on 28 May 2025 recorded its weakest demand since July last year, with a bid-to-cover ratio of just 2.21. The soft result pushed the 40-year yield up to 3.375%, driving a significant steepening of the super-long end of the curve and highlighting the growing risk premia investors now require to hold duration.
This tepid reception reflects broader structural shifts. Traditional domestic duration buyers are stepping back, and the Bank of Japan continues its gradual withdrawal from long-end yield support. These changes are driving curve dislocations, especially in the 30y-40y sector, where we continue to find value through relative pricing anomalies.
Sticky inflation remains a key theme. March's core-CPI print of 2.9% reinforces the view that inflation in Japan is no longer transitory. Yet despite rising price pressures, the BoJ has refrained from hiking again - further entrenching the perception that it remains behind the curve. That misalignment is now increasingly priced into the super-long end.
Cameron Shaw, Portfolio Manager at Ardea Investment Management believes the auction result highlights deeper structural and demand-side challenges:
- Life insurers have little appetite for long duration. Higher domestic rates have reduced liability pressures, and many are now net sellers.
- Pension funds and banks have pulled back from long-end buying.
- Quantitative tightening has barely begun. The Bank of Japan's balance sheet, already outsized as a percentage of GDP, is likely to shrink further, putting more pressure on long-end supply.
- Repatriation flows from FX-hedged foreign bonds could offer support, but holdings are lower than in the past, and large-scale repatriation could create offshore stresses even as it eases domestic demand gaps.
- Overseas investors have been the main marginal buyers, but this reliance increases rate sensitivity to global risk sentiment.
While the Ministry of Finance is expected to reduce JGB issuance in the long end, digestion may remain an issue given these shifting demand dynamics and reduced domestic sponsorship.
The implications for relative value investors are clear:
- Expect more volatility across the JPY curve, not just at the long end.
- With core inflation elevated and the BoJ lagging, short-dated interest rate optionality is increasingly attractive.
- A growing supply/demand imbalance and the early stages of QT are laying the foundation for a richer relative value environment in Japan, including curve microstructure trades and bond-specific opportunities.
In our view, this is just the beginning of a renewed phase of relative value in Japan, driven not by directional rate calls, but by structural shifts and dislocations across the curve. This is undoubtedly market mechanics at work.
