Institutional investors: hedging adjustment to come - Nomura

Analysts at Nomura explained that Institutional investor's hedging adjustments are to come.

Key Quotes:

"Monetary policy tightening by foreign central banks amid the synchronised global expansion makes foreign bonds more attractive. Hedging decisions will be also important for the FX market. 

As short-term rates rise, FX hedging costs for Japanese investors rise. In fact, Japanese lifers lowered their FX hedge ratios steadily before the financial crisis, in tandem with the rising hedging costs. In September 2004 the average hedge ratio was above 50% (54.7%), while it declined to 33.9% by March 2007.

The pace of foreign central banks’ tightening seems to be slower this time. Nonetheless, the hedge ratio is likely to approach 50% gradually from the latest 56.7%. In the past decade, lifers’ foreign assets have doubled to JPY90trn from around JPY45trn. Thus, the impact of a 1% change in the hedge ratio has also doubled. A 5-10% decline in the hedge ratio can now generate JPY4.5-9.0trn of JPY selling over the next one to two years.

However, there are a few differences. From a regulatory perspective, unhedged foreign bond investment is now viewed as much riskier than hedged foreign bond investment. This may encourage lifers to prefer credit risk over FX risk. In fact, the latest Nikkei QUICK bond investor survey shows that more Japanese bond investors find foreign credit products more attractive than EGBs and USTs. Increased investment in credit products in the US and Europe would ease financial conditions in those economies, encouraging more hawkish central bank policies in the medium term. Nonetheless, in the short term, the direct impact of Japanese lifers’ foreign investment on FX is likely to be smaller than in 2005-06 owing to their preference for credit risk over FX risk."