BlueBay AM: Bank of Japan coming under pressure as inflation continues to rise

13 januari 2023

US yields rallied strongly at the end of last week, with labour market data pointing to a more benign outlook for wages, even if job growth remains resilient for the time being. With the inflation backdrop improving, market participants have speculated that a peak in rates in the spring will give way to rate cuts starting in the third quarter.

However, Federal Reserve comments continue to push back on this narrative and with economic activity remaining pretty healthy at the start of the New Year, we think there may be scope for some of these more dovish projections to be disappointed. CPI data is trending lower and will continue to decline in the coming months, as past base effects drop out of annual data.

However, it may take much longer for inflation to return to the Fed’s 2% target than some might believe. Meanwhile, with the unemployment rate sitting at the cycle low of 3.5%, it seems that the FOMC is likely to bide its time before lowering interest rates.

European yields also declined along with Treasuries in the past week. Sentiment was helped by lower Eurozone inflation data last week and by lower energy prices, whose descent has been even more rapid in euro terms, as the single currency rallies from its lows last September.

Economic growth remains close to zero in the Eurozone, with downside risks mitigated by mild weather, energy subsidies and a broadly more expansive fiscal policy stance. The ECB seems to stand firm in its commitment to raise rates above 3% and keep them there through the end of this year.

This being the case, policy tightening is likely to put downward pressure on economic activity in the coming months, meaning that recession in the Eurozone remains likely, even if this outcome is not quite as certain as it once appeared to be.

Meanwhile, yields in Japan came under renewed upward pressure during the past week, as stronger Tokyo inflation data led to increased speculation of a further policy adjustment at next week’s Bank of Japan (BoJ) meeting. Tokyo core price inflation reached 4.0% in December and it seems to be dawning on investors that the ultra-accommodative stance, which the BoJ has maintained under its policy of Yield Curve Control (YCC), has been contributing to this.

Inflation in Japan has become politically unpopular, with this impacting Prime Minister Kishida’s popularity ratings. Early indications suggest that the annual Shunto wage round in the first quarter could see wages rise by more than 3% this year, as workers seek to offset the rise in the cost of living against the backdrop of a tight labour market.

Indeed, it was eye-catching to see that retailer Uniqlo announced a wage rise for some junior staff by as much as 40% in the past week. Meanwhile, Tokyo Metro has announced that fares will rise by 6% in March, marking the first time that prices have moved since 1995. Our concern is that with many prices having been held unchanged for a very long period of time, when they adjust, the step change could be material.

Consequently, we think that inflation in Japan is set to remain above the 2% BoJ target, even as upward base effects around energy prices start to drop out of calculations.

In many respects, the policy of YCC was designed to raise inflation, at a time when policymakers were much more concerned about persistent deflationary pressure, However, it has achieved its objective and so is no longer needed. Yet, one quirk of this policy, is that as it draws closer to its end, so there is a need for the BoJ to buy bonds at an accelerated pace in order to stabilise yields.

In this way, at a time when the BoJ would like to be starting to withdraw policy accommodation, it has actually found itself growing its balance sheet at an ever more rapid pace. In this context, the decision to revise the yield ceiling on ten-year bonds from 0.25% to 0.50% may be seen as a policy error. Consequently, it may be beneficial to exit YCC altogether, rather than adjusting the target further, say to 0.75%, at an upcoming meeting.

Furthermore, in order to maintain the fiction that yields won’t be allowed to rise, so the BoJ is forced into a misleading communication policy, since it is necessary for any policy change to come as a surprise to the market, if it is to avert an outcome whereby it is subject to substantial speculation against the yield peg.

From this point of view we think that it would make sense for the BoJ to change policy sooner rather than later. There should be no embarrassment in this and Kuroda should feel content that he will be handing over an economy to his successor, which looks to be in reasonable shape compared to international peers.

However, the risk is that those in Tokyo remain stubbornly blind to rising inflation pressure, having not seen prices move for more than a generation. Should this lead to a further inflation overshoot, then an end to YCC will need to be followed by hikes in short-term interest rate in the months to follow. This could lead to a much greater destabilisation in yields and speculation that JGB yields could rise in 2023, in a manner similar to the rise in German bunds yields seen in 2022.

In the Eurozone, sovereign spreads have tightened as bunds yields have moved lower, with ten-year BTPs trading down to 180bp relative to Germany. Comments from Scholz this week also revisited the notion of increased joint EU financing (speaking to the challenge of the green technology agenda). This breathed some life into hopes that this could be another small step towards a fiscal union.

However, we don’t think this should be exaggerated. Should the ECB raise rates above 3% for an extended period, then this will depress economic activity and this may weigh heavily on countries such as Italy, where growth remains structurally weak. This is likely to put upward pressure on spreads in our view and so we are inclined to move towards a short position.

However, with risk assets having rallied into the start of 2023, as investors seek to discount a happier backdrop for returns after a challenging 2022, we think that the existing short base can continue to be squeezed in the short term and so we have been inclined to be patient in waiting for an attractive entry opportunity.

New issuance of corporate bonds has been heavy at the start of the year, though demand has risen to match this. As a result, spreads have moved tighter across Investment Grade and higher yielding credit. EM spreads have also rallied, in-line with improved risk appetite across financial markets.

Hopes for an improved China growth backdrop are also helping EM at the start of 2023, and EM currencies and rates have also been performing strongly. Covid disruption will make for a bumpy quarter for China output in the first quarter, but policy easing should lift activity thereafter. Longer term we remain quite sceptical on China’s growth prospects, with aspects of the economy reminding us more of the Japanese economy in the early 2000s.

However, this is a longer-term theme and for now, it seems that sentiment in EM is moving in a more constructive direction. Symptomatic of this improved mindset, markets in Brazil continued to trade better in the past week, notwithstanding echoes of 6^th January riots, which saw pro-Bolsonaro protestors occupy the Senate. In past periods, such events could have triggered a larger re-pricing, but at the current time any weakness in financial markets proved very short lived.

Looking ahead

We are doubtful that the relatively strong market conditions at the start of 2023 can be sustained for too long. We are wary that central banks will disappoint market hopes for more dovish policy. Meanwhile, it seems that economic activity will slow as we progress throughout 2023 putting pressure on corporate earnings, credit ratings and pushing default rates somewhat higher.

On this basis, we have maintained relatively flat positioning at the start of the year and we don’t think it is wise to chase a rally in risk assets. Rather, we are inclined to sell strength and be positioned to buy weakness, as we are particularly concerned by a narrative in markets that we don’t need to listen to central banks, as they don’t matter very much. This may seem complacent and we learned in 2022 just how quickly underlying conditions can change. 

As for Japan, we would observe there is often a strong sense of national consensus. For a long time, this consensus has dictated that there would be no inflation and that JGB yields would not move. However, as this is called into question, so the shift to a new consensus position could occur surprisingly quickly, now that change appears to be underway.