As US rates look to have peaked, Japan rates need to catch up, pushing yen higher
It’s fairly evident that recent US bank failures have been early signs of stress on the system from Fed’s massive U-turn from its ‘transitional inflation” thesis in late 2021. The speed and the extent of its big rate hikes last year were bound to break a few things. However, the repercussions seem more meaningful as it is evident that banks are becoming far more restrictive in their lending stance. This is bound to slow activity even if Fed pauses its rate hikes which the market is betting on, and by chasing growth names and tech stocks.
It is still worth keeping in mind that US regional banks are now under intense pressure to raise deposit rates or risk losing more customers to money market funds and the big banks. This is undoubtedly, bad news for bank margins. Also, slowdown in credit lines is generally entailed by rising loan losses and higher provisions. Moreover, a big chunk of these smaller banks’ assets are long duration treasuries which were supposed to be held until maturity but clearly any run on deposits would force lenders to realise the loss on these holdings.
However, the good news for now is that clam seems to have returned with flight out of regional bank deposit having reportedly slowed, as have inflows to money market funds. With US treasury prices having also rebounded, the unrealised losses look more contained for now and more importantly, better understood. With rise in inflation rates also looking to taper due to its base effect and falling oil price, we are starting to think we might have seen the peak in US long term rates late last year and further narrowing of the 2-10 inversion of the curve could be on the cards.
In our market in Japan, the macro picture could not be starker as BOJ has been suppressing the 10 year rate close to zero since February last year by buying huge amount of bonds in the secondary market. Although Japan’s headline inflation has recently slowed due to big government subsidies, price hikes have spread to railway fairs and utility bills which by next quarter could have a big impact on household costs. Wage increases have also surpassed most expectations as labour shortages are clearly structural and Japan’s fast-ageing demographics look to keep it that way.
We think BOJ’s incoming governor, Ueda-san who takes over the helm on 8th of April, could surprise the market by quickly widening the YCC band, given that the ten-year yield has recently fallen way below its 50bps target. This we think is providing the central bank with a unique opportunity to widen the band, say to 100bps, without too much concerns about its immediate impact on yields. We think improving liquidity and functionality of the JGB market is initially essential in the central bank’s ultimate plan to normalise monetary policy.
With Japan’s central bank owning nearly 60% of all JGBs, most of which are the ten-year bonds, Japan’s banks are nowhere as geared to their own government bond market as US banks appear top be. In effect, BOJ has removed much of that hold-to-maturity risk through its outsized QE. This makes Japan’s banks fairly insulated from that problem lurking in the US financial system.
With the above picture in mind, we think the yen which has strengthened since the US banking crisis first broke, mainly on safe haven inflows, could have much more room to run as we think US treasury yields are looking to trend lower while BOJ will need to start easing off its bond purchases and allowing rates to be determined by its bond market.
