US Bond markets already face a lack of demand from new issues, and now may face further stress due to actions from the Japanese Central Bank.

Inflation has not been a major concern for Japan since early 90s, but now its policymakers are grappling with inflation that's crossed the 3 per cent mark. With inflation above the BoJ’s target, there's probability of a hike in Japan’s Interest rates is increasing. Policymakers are faced with the conflict between worsening economic data, where consumer spending has dropped by 2.1 per cent (due to high inflation) and a 0.5 per cent GDP decrease were both recorded in Q3 2023. Market expectations are for a potential further contraction in the last quarter of the year.

Furthermore, the yen's depreciation against the USD (-12.04 per cent so far this year) is a major factor in BoJ’s thinking. There has been speculation that in October, after sliding below the psychologically important 150 per dollar mark to its weakest level in a year, some market participants believe that the BoJ had intervened to support the currency. Japanese authorities are facing renewed pressure to combat the sustained depreciation of the yen, as investors confront the prospect of higher-for-longer U.S. interest rates while the Bank of Japan remains wedded to its super-low interest rate policy.

If Japan opts for interest rate hikes leading to a rise in government bond yields, a flow of funds back into Japan could be a result which involves the selling of American bonds. Given Japan's substantial holding of American debt, any such move would lead to a reduced demand for US Treasuries and lead to a rise in US bond yields and effectively lead to higher capital costs for the US economy.

In both the United States and Europe, inflation is declining, causing bond yields to fall. German government bonds have hit their lowest point in more than two months as the market anticipates possible rate cuts. However, the ECB reiterated what was already known: bond markets are easing financial conditions, raising a concern in the ECB. If markets anticipate imminent rate cuts, interest rates on bonds such as Euribor and, consequently, bank lending rates could decline. This could create an undesirable effect, contrary to the ECB's objective of curbing inflation beyond 2% and maintaining stability. Some ECB members have even hinted at possible rate hikes.
With the pause in rates and anticipated cuts in 2024, extending the durations of many fixed-income portfolios is becoming increasingly attractive. We note that the flow of capital into long-term treasury funds has increased noticeably as investors start to lock in long-term rates for their asset-liability books. Our view is that rates in the US will remain on hold and the next move will be a cut rather than a hike, it’s the length of this expected pause and the inverted nature of the treasury curve that leads us to prefer positioning on the short end of the curve instead of extending duration.