For the Bank of Japan (BoJ), the introduction of inflation-linked bonds could be mostly good news – as long as it starts to win its battle against deflation.
Ever since Japanese prime minister Shinzo Abe and central bank governor Haruhiko Kuroda took control to combat an overly strong yen and spur growth, the markets’ overall response to the issuance of linkers has been viewed positively by debt capital market (DCM) experts.
This is because the market has started to see signs of economic improvement after the BoJ promised to double the monetary base on April 4.
Helped by a weak Japanese yen, month-on-month core consumer price index (CPI), which strips out volatile fresh-food prices, rose 0.3% compared to March. In similar good news for Japanese policymakers, core CPI for the Tokyo metropolitan area – seen as a leading indicator for prices in the nation as a whole – rose 0.2% in May from April.
One could certainly make an argument for investors to buy inflation-linked bonds as Japan does appear to have escaped deflation.
But it’s a bit too early to get carried away. While month-on month CPI might look good, the year-on-year figures are still in negative territory down 0.4% in April.
To make matters worse, investor euphoria about Abenomics has turned sour in the last few weeks. The Nikkei 225 slumped 6.4% on June 13, falling to a level not seen since the central bank’s April 4 meeting. The yen, trading at ¥103 to the dollar less than a month ago, is now at ¥94. Yields on 10-year government bonds remain low at 0.86%.
All three are signs that investors are turning more defensive amid wider uncertainty over when the US Federal Reserve will unwind its stimulus. Also, the only reason investors might want to buy low-yielding JGBs is if they expect the economy to remain mired in deflation.
If they believed the BoJ’s forecast that inflation will be 2% by 2015, they would not be selling foreign bonds and repatriating money home, which is what they have done since February.
As a result it would seem foolhardy for Japan’s Ministry of Finance (MoF) to go ahead with a plan to issue ¥300 billion (US$3 billion) of linkers – also known as JGBi notes – in October, in what would be its first JGBi issuance since 2008, and a similar volume in January.
For a deflation-prone nation like Japan, the government should maintain a ‘wait-and-see’ approach until market conditions stabilise and it is able to deliver positive year-on-year inflation figures.
If launched amid poor timing, history could once again repeat itself.
For example, Japan’s MoF had to cancel its 10-year inflation-linked government bond auction for the first time in 2008 as rising yields were threatening to increase government funding costs.
Even better would be if the BoJ could tweak some of the JGBi structure to include a deflationary floor – something that was not available in the nation’s previous linkers even though it is a common structure globally. That way, investors would be protected if deflation were to strike again.
Once market uncertainty dies down, the bond, in fact, gives investors a chance to express their opinion on the expected rate of inflation in Japan over the next decade – assuming that the tenor of the upcoming linkers is 10-years. The auction's results will, in part, reflect market sentiment—ranging from the government's forecast that it will achieve 2% inflation by 2015, to more pessimistic forecasts that deflation will persist for longer.
Issuing an inflation linked bond would also provide strong signal that the government is determined to combat deflation, especially at a time when doubts are growing over Abenomics. Perhaps best of all, BoJ will have a hedge against the very inflation it is trying so hard to create.
For Abe’s own sake, he better ensure that the right components are in place, before bond investor scrutiny starts to undo all the good work.