Dollar Slide Drives Budget as Japan Shuns Treasuries (Update2)

By Wes Goodman


April 28 (Bloomberg) -- Add another ailment to the U.S. misery index of soaring gasoline and wheat costs and falling home values: a federal deficit that is burgeoning as foreign investors led by the Japanese recoil from the slumping dollar.

The Japanese, who own $586.6 billion, or 12 percent of U.S. government debt, had their worst quarter in Treasuries this decade, losing 7 percent in the first three months of the year as the dollar fell to the lowest since 1995 versus the yen, Merrill Lynch & Co. indexes show. Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co., three of the nation's four-biggest insurers, would rather accept the world's lowest bond yields in Japan than buy U.S. debt.

``It's too early to say the dollar will stop falling,'' said Masataka Horii, head of the investment team in Tokyo for the $53.1 billion Kokusai Global Sovereign Open, Asia's biggest bond fund. ``The U.S. economy will be slow for a while.''

Japan owns more Treasuries than any other nation. After raising their holdings by $9.2 billion to $620.6 billion between March and July 2007, Japanese investors trimmed that stake by $34 billion through February, the Treasury said April 15.

America relies on foreign investors, who own more than half the U.S. government debt outstanding, to finance a deficit that New York-based Goldman Sachs Group Inc. predicts will expand to a record $500 billion for the year ending Sept. 30, after a $163 billion gap last year. Without their support, long-term interest rates would be 0.9 percentage point higher, a 2006 Federal Reserve study found.

Diminishing Returns

The yield on the benchmark 3 1/2 percent Treasury due February 2018 rose 16 basis points last week to 3.87 percent, according to bond broker BGCantor Market Data. The yield is up from 3.28 percent on March 17, the lowest since June 2003. The note's price declined 1 9/32, or $12.81 per $1,000 face amount, to $97. It was 3.83 percent today in New York.

Ten-year Treasury yields fell to within 2.03 percentage points of similar-maturity Japanese government bonds on March 17, the narrowest margin in more than a decade. Japan's 1.65 percent 10-year yield is the lowest of 31 bond markets tracked by Bloomberg and compares with 4.18 percent for German bunds.

A survey of Japanese funds investing overseas found 58 percent favor euro-denominated bonds, up from 20 percent a year ago, Barclays Capital Japan Ltd., a unit of the world's fifth- biggest currency trader, said in an April 24 report. Kokusai cut its U.S. fixed income holdings to a record-low 20 percent in March, from 32 percent two years ago.

European Debt

``European debt is more attractive than Treasuries,'' said Nobuto Yamazaki, executive fund manager at Diam Asset Management in Tokyo, which runs an $8.55 billion bond fund that is Japan's third-biggest. The euro, which gained 14.5 percent in the past year against the dollar, ``will continue to be strong,'' he said.

Japanese investors have lost 4 percent over the past year after converting interest income and any capital gains into yen, Merrill Lynch indexes show. That compares with a profit of 1.5 percent in Japanese debt and 4.5 percent in German bunds.

The dollar may be rebounding. It appreciated 9 percent to 104.37 yen on April 25 from the 12-year low of 95.76 on March 17. The U.S. currency fell 0.2 percent today to 104.24.

Nippon Life Insurance Co., Japan's largest, is willing to bet on the currency and plans to increase holdings of foreign bonds not hedged against swings in exchange rates by 200 billion yen ($1.91 billion) in the fiscal year that started April 1.

``The dollar at 100 yen is attractive,'' said Tomiji Akabayashi, investment manager at Nippon Life, which has the equivalent of $488 billion in assets.

Fed Concerns

Nippon Life is the only one of the four biggest life insurers willing to take the risk. Meiji Yasuda Life, the third- largest, started hedging dollar-denominated bonds in January and won't be putting new funds into overseas debt, said Yasuharu Takamatsu, head of the investment department. No. 2 Dai-ichi Mutual said it plans to focus on Japanese debt this year.

Investors are concerned Treasuries will fall as the Fed stops cutting its target rate for overnight loans because of faster inflation, said Naka Matsuzawa, chief strategist in Tokyo at Nomura Securities Co., a unit of Japan's biggest securities firm. The cost of wheat and crude oil has almost doubled in less than 12 months, helping push the annual inflation rate to 4 percent in March from 2.8 percent a year earlier.

``There's a high chance the yen will appreciate against the dollar,'' said Hirofumi Miyahara, deputy general manager of investment planning at Osaka-based Sumitomo Life Insurance, the fourth-largest. ``We're cautious on Treasuries,'' said Miyahara, whose firm is increasing purchases of Japanese debt.

No `Charm'

Asian investors outside Japan are also pulling back. Money managers in China, the second-biggest overseas holder of Treasuries, with $486.9 billion, and South Korea say they favor debt in Europe, equities or commodities.

Beijing-based ICBC Credit Suisse Asset Management Co., controlled by China's biggest bank, said last week Treasuries are ``not attractive'' because of currency risks. South Korea's $220 billion National Pension Service in Seoul said yields on the debt have lost their ``charm.''

U.S. borrowing costs will rise in the ``longer term'' because central banks may slowly cut their holdings of dollars to about 30 percent of their reserves in 15 years, from less than 60 percent now, said Kenneth Rogoff, a former chief economist at the International Monetary Fund in Washington.

``The dollar's primacy in the international financial system is being eroded,'' said Rogoff, a professor at Harvard University in Cambridge, Massachusetts. ``Foreign investors have done very poorly in U.S. Treasuries.''

Indirect bidders, a group of investors that includes foreign central banks, bought 29 percent of the $19 billion in five-year notes the Treasury sold April 24, down from 34 percent in March.

``I wouldn't jump into U.S. Treasuries,'' said Hao Kang, who manages a $443 million fund at ICBC Credit Suisse in Beijing. ``I am not so confident about the currency.''