MNI POLICY: BOJ Watching Potential JGB Hike Risk Underpricing

MNI (SYDNEY) - Bank of Japan officials are watching Japanese government bonds as they believe the market may be underpricing the risk of further rate hikes, with yields suppressed by overseas factors including Federal Reserve easing, MNI understands.

The two-year JGB, which best reflects expectations for near-term changes in the policy rate, is currently trading at about 0.445%, showing the market doubts the BOJ will move much higher in the near future after two hikes this year that took the policy rate out of negative territory to 0.25%.

While the commencement of a Fed easing cycle, together with the stock effects of the BOJ’s bond holdings, are contributing to keeping yields lower, investors also doubt that inflation will rise to the Bank’s 2% target and stay there in a sustainable and stable manner in the second half of its forecast horizon.

But officials are confident that data in the coming months confirming wage hikes and the stickiness of inflation will shift the market’s view. The BOJ is prepared to push back against too steep a rise in yields through daily operations, which would expose it to popular and political criticism.

Confidence in achieving its inflation target would allow the BOJ to eventually raise its policy rate to at least 1%, the lower end of the estimated neutral level between 1% and 2.5%. Overnight index swaps only fully price in the next 25-basis-point hike by June.

ENOUGH TIME

While the BOJ expects to resume hiking soon, with a rate increase by as early as December still an outside chance if the Bank is confident that wages data will point to a strong inflationary impulse, officials are also cautious about financial market volatility around the U.S. elections.

Governor Kazuo Ueda said in September that the BOJ has “enough time” to assess the state of financial markets before making its next rates move, and officials are confident it will not fall behind the curve on inflation. (See MNI POLICY: Weaker Yen Ups Dec Hike Chances But US Vote A Risk)

While the 10-year JGBs traded at around 0.950% on Friday, this rate is of less concern to the BOJ, given its close proximity to the lower end of its neutral estimate, which is uncertain and hard to determine without the benefit of hindsight.

However, if the policy rate rises to around 1%, the 10-year interest rate including term premium could rise above 3% when the 2% inflation rate is added to a 1% rise in productivity, which may be too high. 

The BOJ scrapped its yield curve policy in March as it exited negative rates, but has been surprised by market behaviour since.