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Japanese Bonds Signal 8 More Years of Deflation

Sunday, 12 December 2010 12:20 PM

The Bank of Japan’s forecast for an end to deflation in 2011 and 35 trillion yen ($417.8 billion) of spending have done little to change the thinking in the bond market, where investors see eight more years of falling prices.

Bonds designed to protect investors against inflation show that money managers in Japan anticipate prices will decline at an average 0.6 percent pace over the next five years and 0.4 percent annually through 2018. Japan is the only country where bonds linked to price changes show entrenched deflation expectations, according to data compiled by Bloomberg.

“Japan is not going for any aggressive reflationary policy mix and therefore is likely to prolong Japan’s deflation,” said Tomoya Masanao, who oversees funds in Japan for Newport Beach, California-based Pacific Investment Management Co., which runs the world’s biggest bond fund. The BOJ plan was “rather cosmetic,” Masanao said in an e-mailed reply to questions.

Prime Minister Naoto Kan has urged BOJ Governor Masaaki Shirakawa to eliminate deflation that has inhibited growth, allowing China to briefly surpass its Asian rival as the world’s second-largest economy. Japan’s gross domestic product grew by 15 percent during the 20 years through 2009, while the U.S.’s increased 158 percent and China’s surged 20-fold, data compiled by Bloomberg show.

During that period, Japanese prices on products excluding fresh food rose 0.3 percent annually on average, while yields on the benchmark 10-year government bond averaged 2.4 percent. U.S. prices excluding food and fuel climbed at 2.7 percent and the 10-year Treasury yield averaged 5.53 percent.

The Japanese price gauge slid 0.6 percent from a year earlier in October, marking 20-straight months of decline. Deflation, or a general decline in prices, increases the value of the fixed payments from debt and weakens economic growth by damping investment, spending and hiring.

Central bank efforts to boost the economy, bolstered in October by a 5 trillion-yen fund for asset purchases, eased deflation expectations, as measured by the gap between yields on inflation bonds and those that aren’t linked to consumer price changes. The so-called breakeven rate on eight-year securities representing traders’ expectations for average annual deflation narrowed to 0.45 percent on Dec. 3 from as much as 1.32 percent in December 2009.

The BOJ is “fighting and it is working,” said Hideo Shimomura, who helps oversee the equivalent of $59.4 billion in Tokyo as chief fund investor at Mitsubishi UFJ Asset Management Co. “Sentiment is changing and people are becoming more optimistic about Japan exiting deflation, although it will take a couple of years.”

Inflation-linked debt has outperformed government notes over the past six months. An investor who bought five-year indexed securities on June 10 earned a 2.9 percent return, while a purchaser of similar-maturity bonds lost 0.1 percent, according to data compiled by Bloomberg.

Some 150 lawmakers from the ruling Democratic Party of Japan, who call themselves the anti-deflation league, said last month the BOJ should adopt an inflation target to eradicate price declines and bolster employment.

“What the BOJ did in the past has had little impact,” said Akio Kato, Tokyo-based team leader for Japanese debt at Kokusai Asset Management Co., which runs the $35 billion Global Sovereign Open fund, Asia’s biggest. “Investors are skeptical somewhat about the BOJ. It’s up for debate whether they did their best to reach the current situation or just took action after succumbing to political pressure.”

The BOJ said on Oct. 28 that the nation’s consumer prices excluding fresh food will rise 0.1 percent in the year beginning in April.

BOJ Governor Shirakawa and his board on Oct. 5 cut the key overnight lending rate to “virtually” zero, and pledged to keep it there until they can forecast stable prices, which the bank regards as inflation of as much as 2 percent. In December 2009, it created a 10 trillion-yen lending program that was expanded to 30 trillion yen.

“Churning out yen won’t spur demand,” Shinichiro Furumoto, chairman of the ruling Democratic Party of Japan’s fiscal and finance policy panel, said in an interview on Nov. 26.

The yield on Japan’s benchmark 10-year bond reached 1.235 percent on Dec. 8, the most since June, increasing 40 basis points from a seven-year low in October. U.S. yields are rising faster, as data indicate economic growth is accelerating and President Barack Obama’s agreement to extend Bush-era tax cuts spurs speculation the U.S. will have to fund a larger deficit.

The extra yield 10-year U.S. Treasuries offer over similar- maturity Japanese government debt swelled to 198 basis points, or 1.98 percentage point, the widest since July. The difference was 146 basis points on Sept. 7.

The yen weakened to 84.31 per U.S. dollar on Dec. 9 from 83.69 on Nov. 30. Japan’s currency reached a 15-year high of 80.22 to the dollar on Nov. 1 and has advanced 11 percent this year, the biggest gain among developed-world counterparts, according to Bloomberg Correlation-Weighted Currency Indexes.

A stronger yen damps the earnings outlook for Japan’s exporters and may increase pressure for prices to fall by making imports cheaper.

The Ministry of Finance has issued 10 trillion yen of 10- year inflation-linked bonds and hasn’t sold any since August 2008. The amount of outstanding inflation-linked debt is about 4 trillion yen, according to Takashi Nishimura, an analyst in Tokyo at Mitsubishi UFJ Morgan Stanley Securities Co.

Demand for the securities “collapsed” after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008 because of their low liquidity, Nishimura said. The ministry has bought back the securities as needed to avoid supply gluts, improving the breakeven rate’s accuracy as a gauge of deflation expectations, he said.

Japanese government debt has given investors a 1.7 percent loss since Oct. 5 when the BOJ unveiled its asset-purchase plan, according to an index compiled by Bank of America Corp.’s Merrill Lynch unit. The Nikkei 225 Stock Average has advanced 6.5 percent in that time.

Five-year credit-default swaps on Japanese government bonds fell one basis point to 70.6 on Dec. 9, CMA prices in New York show. That compares with 71.1 for China. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to debt agreements.

The extra yield investors demand to own the yen-denominated debt of overseas borrowers rather than the Japanese government fell two basis points to 120 points, according to indexes compiled by Nomura Securities Co.

Three-month commercial paper rates for businesses with the lowest a2 rating fell to an average 0.33 percent, down from 0.4 percent on Oct. 4, according to data from Tokyo Tanshi Co. The rate declined after the central bank said on Oct. 5 it would consider buying commercial paper and other assets through the 5 trillion-yen fund.

Prices are bound to fall in developed nations like Japan, as growth tops out and aggregate demand tapers off, said Daisuke Uno, chief strategist at Tokyo-based Sumitomo Mitsui Banking Corp., Japan’s second-biggest lender with deposits of $850 billion.

“The question in the first place is whether deflation can be defeated,” Uno said. “I don’t think it can be.”

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The Bank of Japan s forecast for an end to deflation in 2011 and 35 trillion yen ($417.8 billion) of spending have done little to change the thinking in the bond market, where investors see eight more years of falling prices.Bonds designed to protect investors against...
Sunday, 12 December 2010 12:20 PM
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