JGB yields likely to follow US rates higher helping financial/cyclical stocks

Stock markets remained highly volatile with a negative bias clearly still in place as US Federal Reserve’s ever more hawkish posture is being digested. As we noted last week, strong earnings results by some should provide pockets of relief rallies in growth names which have been hit the hardest in this year’s sell-off. However, it is also clear that supply disruptions are becoming very challenging for corporations and investors have less tolerance for related earnings misses despite strong underlying demand. What is also evident is that higher input costs are flowing downstream. 

Indeed, Fed’s latest remarks that it looks to actually shrink its balance sheet after its first-rate hike in March falls in line with another of our early 2022 surprises which we outlined back in late December. As we noted then, the US central bank could not only raise rates beyond a quarter of a percentage point at a time to get ahead of inflationary expectations but is also likely to offload some of its treasury holdings to help keep the yield-curve from inverting. 

Despite the above developments, the 10-year treasury yield has struggled to break convincingly above 1.8% and north of its 200-day moving average (which it hasn’t traded above since May 2019). However, with wage inflation running red-hot, it is clear that some key components of the inflation gauge, including rental prices are increasingly becoming embedded into the economy and longer-term rates are likely to remain on an upward trend this quarter.

Certainly, looking at the rising AUM in US money market funds which provide some clues to asset allocations, the steady uptrend towards its all-time pandemic-led highs marked in May of 2020 doesn’t seem to suggest investments into US treasuries are coming back into vogue anytime soon. This is further supported by strong US economic growth as well as continued stream of data which suggest that the latest big wave of milder Omicron strain is fizzling out just as quickly in countries that have been engulfed by the Covid variant and is most likely to spell the end to the pandemic by the end of this quarter. 

Switching focus to our own market, it is very interesting to see Japan’s longer-term rates also climbing higher, trending towards their 6-year highs while still well below levels when BOJ first introduced its misguided zero interest rate policy in 2015 that have crushed lending margins for financial institutions and hurt investment returns for pension funds. Not only Kuroda-san’s super accommodative monetary policy has failed miserably to achieve his inflation target of 2%, even in the current global inflationary back-drop, but has drained much liquidity from the JGB market which could explain the recent spikes.  

Although BOJ has been tapering its QE program for a few years now, simply because there have not been enough government bonds in the secondary market to meet its over-sized buying program, it is increasingly clear that Japan’s government is coming under pressure by the powerful Ministry of Finance to raise taxes to prepare the country for the higher refinancing costs to come. With Kuroda’s experiment generally regarded as a flop, his tenure as BOJ’s chief looks highly likely to come to a close by April of next year when his term ends. This is another factor that could be leading JGB yields higher. 

All of the above developments suggest that Japan’s financial stocks should continue to outperform the market both in the near term and in the medium-term time horizon despite BOJ’s dovish rhetoric. This is also consistent with our view that other cyclical/value names should continue to outperform growth stocks this quarter and we would suggest selling the latter into any relief rallies that may be triggered by better earnings results.