Japan's life insurance giants reduce bullish yen hedges, with positions hitting a 14-year low

On May 30, according to Bloomberg's analysis of the financial reports of Japan's nine major life insurance companies, as of the end of the fiscal half-year on March 31, 2024, these financial giants have reduced their hedging ratio for overseas assets (measures to prevent losses from yen appreciation) from 45.2% six months ago to 44.4%, and significantly down from 63% in the previous year, marking the lowest level in fourteen years.

This means that these life insurance companies have lowered their bets on yen appreciation. In other words, they believe the probability of yen appreciation has decreased compared to before, and thus have reduced their hedging operations. This trend has persisted for three years, even in the context of significant fluctuations in the US dollar exchange rate triggered by the Trump administration's policies.

Ayako Sera, a strategist at Sumitomo Mitsui Trust Bank in Tokyo, stated, the likelihood of the yen regaining its historically strong position has decreased because the real interest rates of the yen are too low.

Life insurance companies believe that the possibility of the yen exhibiting its past strength has diminished and feel the need to hold unhedged overseas bonds to maintain exposure to foreign exchange risks. The real interest rates of the yen are indeed too low.

Dual Blow of Low Interest Rates and High Hedging Costs

The Bank of Japan's policy interest rate remains 3 percentage points lower than the country's inflation rate, and the market expects the next interest rate hike to be further delayed. The market estimates a 64% probability that the Bank of Japan will raise interest rates by 25 basis points before the end of this year, significantly lower than the full bet at the end of January.

The stubborn negative interest rate dilemma and high currency hedging costs are dragging down the demand for overseas bonds from life insurance companies.

Data shows that once foreign exchange protection costs are considered, the compound yield of Japan's 10-year government bonds is more than 150 basis points higher than that of similar bonds in the US, UK, Germany, and Australia. This reality has significantly reduced the attractiveness of overseas assets for Japanese investors.

Such an environment has also forced the life insurance industry to reduce its holdings of overseas assets.

According to the Ministry of Finance, in the six months ending March 31, life insurance companies net sold 756 billion yen (5.3 billion USD) of foreign bonds, marking the seventh consecutive period of such sales. Meanwhile, during the period from October to March, life insurance companies net sold 21.2 billion yen of overseas stocks, after net buying 1.06 trillion yen in the six months ending September 30.

Dismal Yen Outlook, but Fed Rate Cuts May Change the Situation

The swap market indicates an 83% probability that the Federal Reserve will restart rate cuts as early as September. A decline in US interest rates typically helps reduce the dollar hedging costs for Japanese investors, as these costs are primarily driven by the interest rate differential between the two economies.

"For this reason, I expect demand for currency hedging to rebound in the future," said Ueno Tsuyoshi, a senior researcher at Japan Life Research Institute in Tokyo.

For unhedged investments, once currency depreciation offsets the capital and income returns of overseas assets, it may lead to losses. This could prompt life insurance companies to rush into currency hedging, further exacerbating the decline of foreign currencies against the yen