For a decade or two, it's been dubbed the widowmaker (though truth be told, the losses are more bleed than massive capital loss like those holding US growth stocks currently), but as Barclays notes the Japanese bond market 'conundrum' may finally be ready to be played. (or not as we conclude below)
A new bond-market ‘conundrum’ – In Japan?
Michael Gavin, Tal Shapsa
We are always on the lookout for asset prices that seem inconsistent with the more plausible economic and financial scenarios. Sometimes these discrepancies point toward necessary alterations of our fundamental world view. In other cases, they point toward investment opportunity. At the moment, one of the most glaring discrepancies between macro and markets is the long end of the Japanese curve, for which the 5y5y forward JGB interest rate is a perfectly good indicator. This is shown in Figure 1.
A couple of points emerge from Figure 1.
First, the downdraft in forward interest rates dates to the end of 2010, roughly two years before the election of Prime Minister Abe rocked Japanese currency and equity markets. The 5y5y interest rate continued during the subsequent months, perhaps reflecting the ramp-up in BoJ bond purchases that is an important part of ‘Abenomics’. But timing suggests that it cannot all be attributed to the more expansionary policies that were put in place during 2013.
Second, the forward rate is at a level that does not seem compatible with an economy that has recovered from recession and attained something like 2% inflation. The interest rate was, in fact, roughly 100bp higher during the heart of the deflationary period in the early and mid-2000s and during the deep recession (and resumption of deflation) that accompanied the global economic downdraft of 2008-09 (Figure 2).
Finally, until the end of 2012, the downdraft in long Japanese rates coincided with an equally impressive downdraft in global, and specifically US, rates. But the move in Japanese rates continued throughout the 2013 US and global bond market correction. This is not utterly surprising, given the strongly segmented (that is, predominantly domestic) ownership of Japanese bonds. In light of this segmentation, it is not very surprising that the BoJ’s massively expanded bond-buying program pushed rates even lower during 2013. But if this is the explanation, the 2013 US experience highlights the potential precariousness of bond valuations in the eventual normalization of BoJ policy.
Such normalization will likely be driven, if and when it occurs, by successful recovery in and reflation of the Japanese economy. In this context, it is important to remind ourselves that the 3-1/2 year downdraft in longer-term interest rates has coincided with a labor market recovery and (core) price reflation that has been fairly steady during the past decade (although interrupted, of course, by the 2008-09 global event) and is now rather well advanced.
As our Japanese macro team has recently written, the Japanese Phillips curve is alive and well, and it seems to be shifting up in response to the extraordinarily expansionary BoJ monetary policy. The emphasis there was on the finding that the curve has not yet shifted enough to generate 2% inflation at an output gap of zero. This supports our view that the BoJ will decide that it needs to announce further policy easing at its July meeting.
But if we are confronting the long end of the yield curve with the most likely economic scenarios, the next 6-18 months are not the key drivers; we need to move the scenario forward several years. Here, we think Figure 2 supports two important points.
First, after roughly a decade of improvement, the labor market recovery is quite far advanced. At 3.6%, the unemployment rate is now lower than it has been since the late 1990s. The persistence of recovery during the past decade suggests that a full (cyclical) recovery of the Japanese economy is well within sight. It is possible to identify headwinds that may temporarily slow the recovery, but recent experience would seem to argue against the plausibility of a stagnant, low pressure economy as a medium-term scenario that should be priced into the long end of the JGB curve.
Second, the historical experience illustrated in Figure 2 suggests, as our Japanese research team has emphasized, that a tightening of labor markets does eventually generate rising inflationary pressure. It does not take a PhD in econometrics to see this; it is visible to the naked eye in Figure 2, during the 2002-07 phase of the recovery and in its more recent, post-crisis phase.
So although the jury is out on whether inflation will rise to the desired 2% by 2015, if we look ahead a full five years, we would assign a high probability to full cyclical recovery and a normalization of inflation to the 2% range. Along with economic normalization would come, it seems to us, some degree of normalization of monetary policy and the yield curve.
The conundrum, as we see it, is that nothing like this is priced into the JGB curve, which is failing to price even a partial, eventual success of the Abe government's reflationary agenda. Perversely, forward interest rates are even more depressed than they were in the mid-2000s, when deflation was substantially more entrenched, the economy much weaker, and monetary policy less reflationary.
In short, fundamental considerations seem to be at very strong odds with how markets are pricing the long end of the Japanese curve. For the moment, the BoJ's support of the JGB market is the most powerful argument against adopting a sceptical position toward JGB duration. If, as we expect, the BoJ announces an intensification and/or extension of its QE framework, the disconnect between fundamentals and market pricing may be prolonged. But as US bond investors learned in 2013, a policy-induced mismatch between fundamentals and markets can last no longer than the rationale for extraordinarily easy monetary policy. As we have recently suggested , a sceptical position toward Japanese bonds seems like an increasingly sensible way to position for policy success in Japan.
So Is the JGB curve right to discunt now chance of Abe's inflationary policy success? Perhaps that is why Japanese stocks are fading fast and catching on to the reality that printing money is not the solution...?