Friday Rates Update

Hello and welcome to Global Research Unlocked, the interest rates and FX series. This podcast is based on our weekly client conference call, where our strategists, along with guests from other parts of Bank of America Global Research, discuss the most topical and pressing questions faced by our market. I'm Sfiya Salim, Head of European Rates Strategy. It's Friday 23rd of January. My pleasure to have with me Takayasu Kudo, our Japan economist, and Shisei Yamada, Head of Japan Rates and FX Strategy. To discuss what has been quite an eventful week for Japanese markets, we've had an election announcement on Monday, a 25 basis point sell-off in long-dated TGBs on Tuesday, and a VOJ meeting to conclude the week today. Kudo san, let's start maybe with the announcement of the elections for February 8th. Was that expected and what does it mean for the 2026 budget? Hi, thank you for having me. The election was actually out of the brew. Many people had expected that the election to be held within this year, but expected timing was either in April or in July. After the initial budget for the new fiscal year had passed in the ordinary day of session. And due to this timeline, the government can only pass the initial budget up to around end of April, at the artist after the new fiscal year has passed from April. The government will first pass a provisional budget by end of March, and as long as the ruling coalition keeps its majority in the upcoming election, the day will be limited to one month or so, but if they lose the majority, the process could be pushed back further due to renewed inter-party negotiations. Okay, can also the outcome of the election change and the fiscal stance meaningfully? I don't think that any election outcome will meaningfully change the government's fiscal party's stance. The current Takaichi administration is advocating fiscal expansion, and all major opposition parties are also advocating the fiscal expansion. So regardless of the election outcome, the fiscal party's stance in Japan will remain expansionally. However, the main targets of fiscal expansion would likely differ depending on the outcome. So if the ruling party will be against more seats, and PM Takaichi bolsters her political base, she will likely push forward the policy priorities such as the growth-oriented investment with defense and security policy. But on the other hand, if the ruling coalition loses the majority, or only gains a small number of additional seats, then the government would need to compromise with opposition party, the raising the priority of more populous policy measures, including tax cuts, especially consumption tax cuts. From an inflation perspective, are there big differences in implications for the BOUJ tax? I think it could change, but I don't really see a major shift in both the inflation pass and the BOUJ's larger rate health stance. So regardless of the election outcome, the PM Takaichi will remain cautious about the BOUJ's rate hikes, and more populous policy measures could dampen the CPI growth in 2026, on top of the already announced tax cuts and subsidies. However, the more selfish fiscal and monetary policy stance by the administration could fuel the end weakness, leading the higher inflation outlook over the medium-term, and the potential in the bringing forward the BOUJ's rate-high timing. So given the BOUJ needs to take care of the both economic fundamentals and effects trends, I think that any election outcome would not dramatically change the BOUJ's rate-hiking pass down the road. Takaichi noted that she will try not to rely on bond issuance to fund extra spending. Is that feasible? It's highly challenging, so if they really want to achieve the election pledges. Of course, the good news for the government is that Japan's fiscal position has been gradually improving, with the fiscal deficit staying just under the 2% of GDP driven by the continued increase in tax revenue taxed inflation. However, the government has consistently used the additional tax revenue to fund new fiscal measures, including the latest supplemental budget passed just a month ago. So any further fiscal expansion in the election pledges require the additional bond issuance and this may make the significant spending cuts or these taxes to offset costs, but it seems hard to achieve from the political perspective. Thank you, Kudo-san. Yama does not turn to you, therefore, but this difficulty not to think about higher bond issuance ahead, is that what triggered the dramatic sell-off in long-dated JGBs on Tuesday? Yes, so I think the trigger was exactly "Takaichi's call for the consumption tax cut on Monday," right after opposition parties called for the tax cut. So this sparked concern of fiscal populism, because Takaichi once denied the tax cut last fall, and the market kind of felt Takaichi was making a gradual pivot toward balanced policy and realism. After she let the B.O.J. hike in December in 2026, budget was more constrained than some had expected. So that tax cut headline came as a surprise to the market. And also, the market was positioned for a flatness, so I think positional unwinding exacerbated the move. Data also show lifers were active seller in super long JGBs in December, so they may have also sold these JGBs additionally at this week. Someone who doesn't say that the slow hiking cycle from the B.O.J. is behind the steepness of the curve, because front end rates are too low, and the expectations of further hikes are limiting demand, maybe from lifers here, so do you buy into this explanation? Yes, I do. I mean, the B.O.J. being behind the curve partly explains the end weakness and the steepness of the curve. You know, inflation has been running at 3%, policy rate is still at 0.75%, it's just low. I mean, if we even assume 2% inflation, still, the real policy rate right now will be -125 bits, it's low, and that has contributed to, again, steepness of the curve, and also rising inflation expectations. The 10-year break even is at close to 2%, it was only like 1.6% several months ago. Could the Sun coming back to you? Did the B.O.J. acknowledge any of that in the meeting today? And what are your key takeaways? To be honest, there were not many meaningful takeaways from today's B.O.J. policy meeting. B.O.J. kept its policy rate unchanged at 0.75% as widely expected, following the 25-based one-hiking December. One hawkish member descended, uncalled for a back-to-back hike, but there wasn't a complete surprise either. And in the latest focus, the B.O.J. revised after growth and inflation focus, but revisions were largely consistent with their messages at the previous December meeting. And also, at the press conference, the governor will refrain from making any meaningful comments on the latest effects moves and the sharp rise in the ongoing G.V. years. So all in all, the B.O.J. kept the maximum flexibility for the future rate hikes and the potential bond buying operations. And today's meeting offered a very little new information to the market. You might have found that in this context, I mean, do you still see the possibility that the B.O.J. would intervene if we were to see significant additional sell-off in long-dated years, and what are the tools that it has at its disposal? They have some tools and they have used these tools in the past. They could boost a regular bond buying operation or conduct emergency operations. They could also do unlimited fixed-rate purchase operations. They could also do what's called a fund-supplying operations against pooled collateral and let financial institutions buy GGBs. I think the hurdle is high. The bond market intervention could exacerbate the en weakness. And also, I think that the bond market sell-off is also a natural reaction to tax cuts. And the B.O.J. would not want to intervene so easily. Do you see any potential trigger levels, then? I think, you know, the market should destabilize further or the yield should go up to the level that could constrain the government budget, the trigger intervention. You know, the B.O.J. didn't really give any signs of immediate intervention today, so I think we're still far. The B.O.J. estimates the neutral rate range as 1% to 2.5% in the nominal term. And also, I think, you know, policymakers, they want to avoid the 10-year yield to exceed 3%, which is the rate assumption used in compiling the next year's budget. So I would say if the 10-year yield breaks significantly above 2.5%, and moved toward 3%, then the risk of intervention will increase. How about ethics now? The end was able to stabilize this week, because the USD came under pressure on tariff headlines. But it was quite volatile today, plus B.O.J., do you foresee any additional end depreciation that would require B.O.J. intervention? Our assumption is, you know, they would intervene around 162 to 165, but, you know, if it were actually despised or Japanese equities and JGB, it's a lot, along with, again, intervention could occur at lower levels. The election is coming up on February 8th, so, you know, the government has to make sure, you know, that yen is under control. They don't want, you know, all these headlines that could damage them politically. So, yeah, they are ready to intervene if they need to. Now coming back to JGB and the timeline ahead, we have the election on February 8th, but in the intermediary budget in March, and maybe new one in April, so when would you expect revisions to JGB issuance to be announced? Even if they want to cut the tax, it takes time to prepare. And also, I think they will prioritize passing the budget as it has been drafted so far. And any tax cards will come later. I don't think the government will change the issuance plan for the coming fiscal year right after the election. Then I guess the next timeline is already summer when the government usually compiles the medium term policy plan, and we kind of know the direction of fiscal policy. And then I think we get clarity on, you know, the issuance going forward. Thank you very much, Susan, and Nivela, for joining today and providing your insights. Now, wish everyone a very good weekend. Thank you for joining us today. We hope you found this useful, and that you'll tune in next week. 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