Japan Rates Strategy: Fading Inflation Risk but Chasing Fiscal Risk

Research evidence excerpt

Japan Rates Strategy: Fading Inflation Risk but Chasing Fiscal Risk

IdeaM

Interest Rate Strategy

Japan | Fading inflation risk but chasing fiscal risk

Koichi Sugisaki

MORGAN STANLEY MUFG SECURITIES CO., LTD.

koichi.sugisaki@morganstanleymufg.com +81 3 6836-8428

Hiromu Uezato

hiromu.uezato@morganstanleymufg.com +81 3 6836-8431

Renewed fiscal risk premium emerged

Middle East tensions have continued to flare up again from time to time, but the US and

Iran continue to engage in discussions, and we have also been seeing a gradual increase in

the number of tankers transiting the Strait of Hormuz.

North Sea Brent crude prices have been declining against this backdrop and our

commodities strategists have recently lowered their oil price forecasts.

The breakeven inflation rates (BEIs) priced into JGB linkers have also been falling, but the

term premium priced into the 10y JGB sector meanwhile appears to have widened this

week in line with a widening of the residual for our OIS fair value model implied by 10y

UST yield and BoJ rate hike pricing (MSP0KEJP Index) (see Exhibit 1 and Exhibit 2 ).

Sell-off in JGB term premium and the deviation from fair value have moreover been even

more pronounced for the 30y sector than for the 10y sector, suggesting to us that the

residual might now be reflecting a wider fiscal risk premium.

Exhibit 1: Cumulative change in JGB term Exhibit 2: 10y OIS residual versus 10y JGBi

premium across the curve since Middle East breakeven

tensions and 10y JGBi breakeven

Source: Morgan Stanley Research, Bloomberg

As had been foreshadowed in the media, the draft version of the Takaichi administration’s

first “Basic Policy on Economic and Fiscal Management” released on June 30 calls for over