Firmer US data prints and renewed interest in the Federal Reserve’s exit strategy from its bond-buying programme caused core government bond underperformance at the beginning of May.
This was then magnified in Japan where the US dollar and Japanese yen breaking through 100 pushed the Nikkei and Japanese government bond (JGB) yields higher.
Since April 4, when the Bank of Japan (BoJ) announced an aggressive monetary policy target of ‘2in2’ (2 per cent inflation in two years’ time), 10-year JGB yields have more than doubled from an intra-day low of 0.33 per cent to 0.85 per cent as at May 17.
Given the amount of JGBs, the BoJ has committed to buying – 70 per cent of gross issuance, more than 100 per cent of net issuance – an expectation of lower JGB yields might appear reasonable.
But with the BoJ explicitly aiming to raise inflation expectations, the initial knee jerk reaction of lower yields has been replaced with a realisation that higher inflation is the enemy of a bond investor.
You only need to look back to the periods following the first and second quantitative easing announcements by the Federal Reserve and the reaction of the US Treasury bond market to see this in action.
For an economy mired in deflation for the past 15 years, owning JGBs even at low yields has delivered positive real returns.
There remains significant scepticism that the BoJ will be able to engineer their ‘2in2’ target, but for the time being, the market appears to be giving them the benefit of the doubt.
One of the consequences of raising inflation expectations could be higher bond yields, which would be seen as undesirable by the BoJ as they will want JGB yields to remain low to aid the recovery.
For the past few years, there have been numerous discussions about the road map for western developed economies being like that of Japan; a ‘lost decade’ with government bond yields remaining lower for longer.
There is now a debate as to whether the BoJ would actually like the road map for Japan to be that of other developed economies: inflation higher than government bond yields… negative real yield.
Iain Stealey is portfolio manager of the JPMorgan Global Multi-Sector Income Strategy
