Inflation Special Report

All of a sudden, inflation has become the most keenly watched figure in the financial markets. Analysts, economists and traders are scrutinising every single release for signs that inflation is on the up, with the rates markets zipping up and down on the back of differing perceptions over the timing of further interest rate moves.

The Japanese market, for instance, has had a fairly torrid time. With the consumer price index pushing into positive territory and the Bank of Japan (BOJ) ending its quantitative easing policy in March, Japanese government bond (JGB) yields shot up on expectations the BOJ could raise rates as early as this month. However, some analysts now think a 15% drop in the Nikkei 225 stock index between May 8 and June 21 has caused the central bank to stay its hand amid fears that a rate rise could exacerbate stock market volatility. As a result, JGB yields have fallen sharply again.

But regardless of the timing of a BOJ move, the Japanese economy looks a lot stronger than it did just a few years ago, having pulled itself out of a deflationary spiral that engulfed the country for the best part of a decade. That's good news for the nascent inflation-linked JGB market. After a slow start in 2004, more investors - both foreign and domestic - have invested in these instruments. For their part, the Japanese authorities have done what they can to stimulate growth - the Ministry of Finance has increased issuance every year since launch, and has lifted restrictions that initially prohibited foreign investors from entering the market. The country's accounting standards board has also allowed inflation-linked bonds to compete on an equal footing with JGBs.

Nonetheless, inflation-linked bonds are still a tiny proportion of the overall JGB market. What's more, the country's pension funds - considered key to the Japanese inflation market's success - have yet to show any real enthusiasm for the product (see pages 64-66). The inflation-linked market has come a long way in a relatively short time, but there's still a long way to go.

Nick Sawyer, Editor.