Japan Rates Strategy: Fade the Inflation Scare, Stay Constructive on the JGB Belly

Research evidence excerpt

Japan Rates Strategy: Fade the Inflation Scare, Stay Constructive on the JGB Belly

IdeaM

Exhibit 1: June MPM pricing and market-implied Exhibit 2: Estimated inflation risk premium across

pace of hike in the following 12 months OIS curve

%

Source: Morgan Stanley Research, Bloomberg

Source: Morgan Stanley Research, Bloomberg, Note: inflation risk premium is

estimated as the residual of OIS fair value model, which includes market-implied pace

of BoJ hikes in the following 12 months and 10y UST yield

That said, it is not as though the inflation rate premium continues to hit new highs, and

JGB linker breakevens have basically just been drifting sideways of late even as the Middle

East situation has heated up before the possible cease-fire deal (see Exhibit 3 ).

Moreover, (North Sea) Brent crude oil has not climbed back above USD100/bbl despite

the latest turn of events. As our commodities strategist colleagues have pointed out, it

would indeed appear that the impact of the Strait of Hormuz shutdown has been offset,

to at least some degree, by a combination of reduced demand from China and increased

supply from the US and other oil producers outside the Middle East.

There is, of course, still a risk that oil prices could climb once again under a protracted

conflict scenario due to demand for oil picking up over the northern summer and markets

starting to focus greater attention on dwindling inventories in the US and elsewhere.

We believe the inflation risk premium could obviously widen yet further in the short term

if prices should climb well above USD100/bbl. That said, the resultant tightening of

financial conditions would be liable to refocus market attention on downside risks to

economic growth and could accordingly serve to limit widening of the inflation risk