Lombard: GPIF's overweighting of Japanese bonds may trigger global carry trade unwinding; Banco Santander: GPIF may sell $62 billion in US Treasury bonds!

The asset allocation trends of GPIF, Japan’s largest pension fund in the world, are becoming a new source of systemic risk in the global bond and foreign exchange markets.

TS Lombard and Banco Santander recently released reports indicating that GPIF is accelerating its return to Japanese domestic bonds, and its scale may have a substantial impact on the yields of US and European government bonds.

According to estimates by Banco Santander, even without triggering a formal asset allocation review, GPIF could reduce its holdings of U.S. Treasury bonds by up to $62 billion within the current policy framework.

TS Lombard further pointed out that this structural capital inflow will push USD/JPY below 150 and toward the fair value range of 130 to 140, while the passive deleveraging risk of global carry trades has not yet been fully priced in by the market.

Currently, Japan's Health, Labour and Welfare Minister Kenichiro Ueno has confirmed that officials are studying whether a review of GPIF's asset allocation is necessary, but no formal decision has been made. Meanwhile, GPIF's domestic bond allocation had risen to 27% by the end of March, exceeding the benchmark target of 25%, indicating that there is still room for a 4% increase without changing current policies.

The market has not yet fully priced in this potential shift, and speculative short positions in the yen remain high.

The divergence between exchange rate and interest rate spread convergence is disappearing.

Over the past two years, the spread between the US and Japanese 10-year government bond yields has continued to narrow, but the USD/JPY exchange rate has remained near historical highs, forming a rare long-term divergence.

TS Lombard believes that the yen is re-linking with interest rate differentials, and if this convergence trend continues, downward pressure on the exchange rate will persist.

The key factor supporting the yen's weakness has historically not been interest rate differentials themselves, but rather the sustained large-scale capital outflows from Japan. Japan's massive current account surplus has long been submerged by portfolio fund outflows and carry trade transactions.

Over the past two years, despite rising domestic asset yields, Japanese investors have continued to buy overseas assets. Now, this behavior is reversing – capital is flowing back to Japan, making the repatriation itself the structural driver of the yen's strength, replacing official intervention.

The yield on Japan's 10-year government bonds touched 3% last week, the first time since 1996, driven by inflationary pressures, concerns about fiscal spending, and market expectations that the Bank of Japan would accelerate interest rate hikes.

TS Lombard predicts that the Bank of Japan will resume quarterly rate hikes starting in January 2027, with the terminal rate reaching 2% in the fourth quarter of 2027. The direction of narrowing interest rate spreads has been established.

GPIF Redirection: Structural Return Signal

GPIF currently manages approximately $2 trillion in assets, making it the world's largest pension fund and one of the largest single foreign holders of U.S. Treasury bonds—according to data from the U.S. Treasury Department, Japan holds a total of $1.1 trillion in U.S. Treasury bonds.

Any marginal change in GPIF allocation behavior is enough to have a perceptible impact on the global fixed income market.

As of the end of March this year, GPIF's domestic bond allocation had risen to 27%, higher than the benchmark target of 25%. Under current policy, the fund is allowed to fluctuate within a 5 percentage point range above and below the benchmark, meaning a maximum allocation of 31%. Currently, there is still approximately 4 percentage points of room for further allocation above the upper limit.

TS Lombard points out that this shift may only be just beginning.

In a report to clients, a team led by Antonio Villarroya, Global Head of Fixed Income, FX and Commodities Strategy at Banco Santander, wrote: "Given the flexibility afforded by the strategic allocation range, GPIF can begin reducing its foreign bond holdings in the coming months without waiting for a formal strategic portfolio review."

The bank's model scenario assumes that GPIF will reduce its foreign debt allocation from the current level to 20% of its portfolio—still within the limits allowed by current policies—and calculates a potential reduction of up to $62 billion in US Treasury holdings, with the risk of selling concentrated in US Treasury bonds.

Villarroya's team added that if the Bank of Japan successfully pushes the yen stronger through successive interest rate hikes, the aforementioned reduction path will be more likely to be implemented.

Carry trade encountering volatility, 150 non-fair value

The logic behind carry trades is based on low volatility: as long as the yen exchange rate remains stable, the interest rate differential from borrowing yen and allocating to high-yield assets can continue to accumulate. Once yen volatility rises, the risk-adjusted return of shorting the yen will deteriorate rapidly, forcing leveraged positions to shrink.

TS Lombard points out that official intervention is merely a catalyst; volatility is the key variable that translates intervention into broader liquidation.

TS Lombard's relative price and interest rate model shows that the fair value of USD/JPY is between 130 and 140. The current price of around 150 is not a support level from a fundamental perspective, but is more likely just a threshold to the new system.

The market has not yet positioned itself for a full revaluation of the yen – speculative positions are still mainly shorting the yen. Once USD/JPY decisively falls below 150, forced covering may become the main driving force in the next stage.

A stronger yen may trigger a rebound in the VIX index.

TS Lombard points out that the impact of the yen's appreciation extends beyond the exchange rate itself, and has the potential to spread to global assets.

If USD/JPY experiences a disorderly decline, it could force cross-asset carry trades to deleverage, escalating the yen's rebound into a broader volatility event —something inherently similar to the global stock market turmoil triggered by the yen's sharp rise in August 2024.

TS Lombard believes that going long on stock volatility is an effective tool to hedge against the aforementioned tail risks after the recent decline in the VIX, and warns that if the GPIF, this "super tanker," continues to accelerate, global volatility may not remain dormant.

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