Goldman Reinforces The Bass-Grice Japan Inflation Thesis: Issues 6th Top Trade Of 2011 - Buy 5 Year JPY Inflation Swaps
The two most prominent defenders of the Japan-inflation theme, Dylan Grice and Kyle Bass, have just gotten a key reinforcement:Goldman Sachs. Last night, Goldman released its much anticipated 6th trade, to its roster of top trades for 2011. It just happens to be a bet on Japanese inflation. Which, however, begs the question - is this one of those trades where Goldman is, naturally, on the other side and is selling Japan inflation to clients. If the performance of the Squid's Top 10 trades for 2010 is any indication, we would be very cautious, although the fundamentals presented previously by Grice and Bass certainly present a very convincing case for why Tokyo may soon have no choice but go schizo with money printing (all over again), only this time with the gusto previously exhibited only by such monetary madmen as von Havenstein, Gono, Mugabe and, naturally, von Bernankestein.
From Goldman Sachs Global Markets:
Trade Update: Recommended Top Trade #6: Long 5-yr JPY Inflation Swaps
Over the past several months the major inflation markets have moved to price in a significant acceleration in headline inflation, reflecting higher commodity-led inflation, as well as a gradual erosion of spare capacity. By contrast, prospects for higher inflation are still under-appreciated in Japan, as Fiona Lake argued recently. In inflation markets, Japanese inflation swaps have been clear laggards relative to their peers.
Granted, the re-basing of the Japanese CPI, due this August, should shave around 40-50bp off trailing inflation. But this one-off adjustment is most likely in the price already and an upside surprise to this estimate would likely have little effect on intermediate inflation. Moreover, consumption tax hikes in the coming years are not in the price, yet the probability of such a move is non-zero.
From a valuation standpoint, intermediate inflation swaps appear to be fairly valued, as is the case for most of the other G4 inflation markets. However, our analysis suggests a rapid increase in equilibrium inflation swap rates from -10bp currently to around +50bp in Q3. This is based on a regression analysis, which suggests that inflation expectations and short-dated inflation swaps do not fully reflect the non-core inflation pressure in the pipeline.
Moreover, a Z-score analysis across the G4 markets suggests that intermediate JPY inflation swaps are lagging their peers: specifically, JPY inflation swaps are around -4.0 standard deviations below the pre-crisis ‘norm’, compared with Euroland and US swaps, which are - 1.5, -1.0 below the 'norm' respectively.
On this basis, we would recommend holding 5-yr JPY inflation swaps as a strategic trade for this year. Currently at -13bp, we see them rising to around 40bp by Q3. We expect the cost of carry to be flat over the coming 6-months and to rise thereafter.
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