BoJ target leaves Japan inflation swap market unmoved

Doubling Japan's inflation target has been viewed as a big deal internationally but players on the ground say the impact on the domestic inflation market has been limited

The decision by the Bank of Japan (BoJ) last week to set an explicit 2% inflation target to bring the country's economy out of over two decades of near constant deflation has driven far smaller changes in the domestic inflation market than the move at the end of 2011 to double the country's sales tax.

On Monday the breakeven point on a two-year inflation swap stood at 100 basis points – just 4bp higher than before the BoJ's move. Partially this is explained by a 20bp increase since early December when markets starting explicitly pricing in the likelihood of an inflation target, however, this is still much smaller than the shifts that followed the decision to introduce a sales tax.

In a move that was highly controversial at the time, the previous government of prime minister Yoshihiko Noda decided to double Japan's sales tax to 10% by 2015, increasing it by 3% and 2% increments respectively in 2014 and 2015.

According to Yuya Yamashita, Tokyo-based rates strategist at JP Morgan, at the time of the announcement of the sales tax increase the two-year breakeven point stood at –27bp, before increasing by over 80bp during the 12 months of the legislation's passage through parliament.

"Since mid-December 2012 JPY inflation swaps – and also the breakeven inflation rate of inflation-linked Japanese government bonds (JGBIs) – have had some pick-up, from both Abe's landslide victory in the election and the prior expectation that the BoJ would construct an explicit inflation target. But these pick-ups are not significant given a 100bp rise in both swaps and bonds experienced since the previous PM Noda's administration," he says.

But Yamashita says this means there is potential for rates to widen if inflation is actually realised.

"The current level of rates for inflation swaps and the breakeven inflation rate of the JGBI are sufficiently low relative to the BoJ's 2% inflation target. There is still large room for upside in these rates in case the markets price in the BoJ's inflation target further," says Yamashita.

The construction of Japan's inflation market makes predictions difficult – while JGBIs are mainly held domestically over 90% of the inflation swap market is owned by international investors, according to Yamashita.

"The inflation swap market is one way. It's overseas investors looking to take the inflation-receiver leg: they appear to believe that the Japanese inflation rate will rise towards 2%, but I'm not sure about the time horizon they have in mind.

"On the other hand, domestic investors are cool regarding inflation because of the 20-year deflationary period. It's hard for them to imagine that the Japanese inflation rate will reach the level expected by international investors."

The head of the Japan rates business for another international bank in Tokyo typifies local pessimism over the future direction of inflation, characterising the BoJ's actions as too timid.

"I would have expected more robust action from the BoJ in order to actually meet this inflation target. What has been done is the minimum – interest rates could have been cut further, or the asset buying programme extended. BoJ governor Masaaki Shirakawa's term ends in April and it's unlikely he will take more action before he leaves the central bank."

Domestic scepticism aside, another rates strategist at an international bank in Tokyo, however, says there is potentially a "big opportunity" for the inflation swap market to increase volumes given current conditions, even if the BoJ inflation target is not met.

The strategist cites yen weakening as a potential driver of imported inflation. The yen has strengthened in recent years due to its status as a safe haven currency. However, concerns over the direction of the new government has seen the dollar/yen exchange rate fall by 12% since the start of December, and it now trades at 92 to the dollar – an amount that one Hong Kong-based forex structurer says is "highly unusual for a G-3 currency in such a short space of time".

Even so, according to the head of rates, there will have to be a prolonged trend of increasing inflation to persuade the biggest likely onshore buyers – pension funds – to re-enter the market.

"The whole issue with inflation is about the trend, not the actual numbers. For example, there was a small percentage increase in Japan inflation in the years between 2005 and 2007, when the economy was good and CPI [consumer price index] went over 1%.

"But because domestic players didn't see these price rises continuing in the long term, they didn't hedge at all. But inflation is unlikely to occur in a sustained manner without more robust action by the government – allowing large-scale immigration, for example."