BMO’s Davis Warns of Japan as Next Potential Bond ‘Hurricane’

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(Bloomberg) — Investors digesting tumult in British bond markets in recent weeks should keep an eye on Japan, home of some of the world’s biggest international investors.

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Earl Davis, head of fixed income at BMO Global Asset Management, joined a chorus of analysts worried about potential turmoil in global markets if the Bank of Japan shocks investors by tightening monetary policy. And it could be even worse than that caused by the UK’s recently abandoned economic plan.

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“One of the biggest risks in the bond markets that I’m aware of in regards to the repricing and why things could get cheaper is actually Japan,” said Davis in an interview with Bloomberg. 

The BOJ, which holds its next meeting between Oct. 27-28, currently keeps a 0.25% ceiling on 10-year yields in a bid to boost Japan’s stuttering economy and secure stable price and wage growth. 

It’s not Davis’ base case, but “if they take away that peg, the bonds will reprice at a higher yield,” he said. Such a move could be what causes the next “hurricane across the world” of bonds, he added.

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Read More: Violent Market Swings Await Day the BOJ’s Yield Anchor Lifts 

Monetary policy makers insist that the BOJ is nowhere close to even a modest adjustment to its ultra-easy policy. The 10-year bond hasn’t traded on some days recently as the central bank buys the most of the available securities, and the BOJ announced an unscheduled bond-purchase operation earlier this week.

Canada Value 

Japanese investors, including pension funds, have been net buyers of an average of 709 billion yen ($4.8 billion) per month of such securities over last 10 years to August, according to government data. Any increase in domestic bond yields may make it harder for Japanese investors to maintain their current holdings of foreign securities.

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Even as Japanese investors have been net sellers of Canadian long-term debt securities during most of this year, they remain net buyers over the last decade and their pullback could spark volatility. BMO Asset Management, which had C$152 billion ($111.2 billion) of assets under management as of the end of June, is weighing opportunities.

Absent any big market surprises, Davis is getting ready to overweight Canadian credit markets, and corporate bonds in particular, where he sees value. The yield investors demand to hold Canadian dollar corporate and provincial bonds are at the highest in almost 14 years, according to Bloomberg index data. 

“The valuations right now, in regards to the coupon you’re getting, look very attractive based on the past 10 years,” said Toronto-based Davis. “We think they get more attractive,” he added.

Rate-swaps traders are pricing in that Bank of Canada main rates will peak around 4.5% by April 2023, and that they could reach 5%, Davis said. BOC is scheduled to hold its next monetary policy decision on Oct. 26.

“Once we get into that window, we will start buying credit or taking off our hedges,” said Davis. That’s “because we believe at that level, you hit basically where we think inflation’s going to come down to plateau around that 5% level.”