She predicts yields on the 10-year will rise as high as 2% by the end of the 2006 fiscal year (end March). These securities havenÆt yielded higher than 1.6% for the past six years but yields finally began to nudge upward in April, when the government first declared the end to its æquantitative easingÆ strategy of zero interest rates, designed to combat deflation.
She bases that on the assumption that the uncollateralised overnight call rate (the O/N, JapanÆs equivalent to the US federal funds rate) will rise by 25 basis points to 50bps this autumn. The historical average spread between the O/N and the 10-year bond is 147bps; tack on 50bps and youÆve got 200bps, give or take a few. Fundamental economic indicators point to 1.86% 10-year yield, Hasegawa adds. That will remain the new ceiling for 2007; if conditions allow the Bank of Japan to raise interest rates again in late 2007, the 10-year may yield as much as 3% in 2008.
Despite yields trending upward on the long end, Hasegawa predicts the JGB yield curve will flatten. The short end will be marked by the return of volatility, but structural demand for long-term assets by domestic pension funds and insurance companies will ensure higher prices for 10-year bonds. And if yields do rise, new investors such as commercial banks will also start buying long-term bonds.
The markets have responded to the BoJÆs recent policy signal in a number of ways. The three-month euro-yen futures yield curve has steepened in recent weeks in anticipation of higher short-term interest rates. The government has been sucking up excess liquidity left over from æquantitative easingÆ, and the Bank of JapanÆs current account balance surplus has fallen from Ñ30 trillion to Ñ10 trillion in just a few weeks.
With growing pressure on the O/N, banks have stepped up funding in the money market. While regional and city banks have sold Ñ4.4 trillion of JGBs in March and April, trust banks have become net buyers.
Going forward, market movements will reflect JapanÆs macroeconomic picture, says Hasegawa, who spoke at a Euromoney bond conference in Hong Kong. Mitsubishi UJFÆs view is that JapanÆs economic recovery is self-sustaining, but a slowdown in the United States will have an impact in the second half of this year, reducing JapanÆs GDP growth for FY2006 to an estimated 1.6%. She adds, however, that the firm believes this to be a temporary lull, and that JapanÆs GDP growth should hit 2.8% in FY2007.
While that may bode well for a more aggressive monetary stance, she suggests the BoJ will have to be moderate. Year-on-year core consumer price inflation is 0.5%, and that mild number includes oil prices. Take out energy costs, and inflation is nil. She expects, therefore, the BoJ to raise O/N rates by 0.25% in September and then pause, probably for a full year, for the US and Japanese economies to resume steadier growth, before it can begin to raise rates more consistently.
Similarly, news on the corporate front will force the BoJ to go slow. Corporations have seven-year record profits in Japan, thanks to restructuring. This growth is now feeding into households, as unemployment falls to 4%, the lowest level since 1990, so average employee income is rising. But the IT cycle seems to have hit a peak, with inventories now rising at 10% year-on-year; other indicators suggest the current expansion is maturing. Household wealth increases are neutered by rising costs for pensions, healthcare and taxation. And productivity gains across sectors (driven by demographics: as baby boomers retire, their jobs are taken up by lower-salaried workers) will keep a lid on unit-labour costs, another reason why inflation will remain muted.
Hasegawa says the main risk to this outlook, beyond a severe economic crisis in the US, is government fiscal policy. The government must eliminate its budget deficit by 2011, which means cutting expenditures and/or raising taxes. With the prime minister, Junichiro Koizumi, due to step aside in September and elections to the DietÆs upper house scheduled for the summer of 2007, leading factions in the Liberal Democratic Party are keen to publicly discuss just about anything but how to tackle the budget deficit. But if the post-Koizumi government is viewed as fiscally weak or frivolous on this issue, the bond markets will respond by imposing risk premiums, Hasegawa warns. And that will make it even more expensive for the government to address its debt burden.
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