Japan: Why the world is watching

0:01Patrick Coffey:Welcome back to the Barclays Brief. So Japan is back in the headlines. It's the world's fourth largest economy, home to one of the world's largest bond markets. And it's also one of the biggest pools of capital anywhere globally. That means changes in Japanese interest rates and bond yields can and do influence where investors put their money both at home and abroad. So, as we've been reminded recently, what happens in Tokyo doesn't just stay in Tokyo. If we zoom out, for decades, Japan was defined by deflation, zero interest rates, and a weak yen. But that's changing quickly. Inflation is back, rates are rising, and just a few weeks ago, we saw something remarkable.

0:46Patrick Coffey:Japanese authorities intervened to support and strengthen the yen with the US joining in for the first time in decades. It means it's a great time to talk about Japan today because we have a very unusual combination of weak currency, rising bond yields and a very strong equity market as well. So what's going on? Why does the yen remain weak? What's the Bank of Japan trying to achieve? And how should global investors think about this? Joining me to discuss all of that is Yoichi Takamura, head of macro trading in Japan. Taka, thanks for being on the podcast with me today. Pleased to be here. Thanks for inviting me and I look forward to speaking about Japan.

1:28Patrick Coffey:Thank you. So it's the end of your day. It's the start of mine over here in London. So Japan's obviously been back in the headlines. Investors care a lot about it. And the yen has been one of the biggest market stories. Why is it so weak despite Japan finally emerging from decades of ultra low inflation and raising rates? I think it's mainly because of capital flight. The Japanese household still has 50 % of the assets in cash. And for the last three decades, when there was a deflation, people were happily sleeping with the cash under the pillow. Since pandemic, inflation started happening. People started panicking.

2:08People put the money into equities and real estate. And some, of course, into foreign assets. And that has been driving bigger currency, which is my capital plight.

2:19Patrick Coffey:Sure. And so we've seen very strong Japanese equity performance the last year or two. Let's just focus on that currency intervention. So the MOF intervened a few weeks ago and the US followed suit. How is the market digesting those interventions? What happened to the yen? And what's the market now expecting? Let me explain why Japan needed FX intervention. Japan imports 90 % of energy and 60 % of the food. And there's a limitation of how far the weakness of yen can go, given that affects inflation for households. And 162 was the player level where the market broke that level last month. Japan could have done slow intervention, but instead asked to help from the U.S.

3:09It ended up becoming a coordinated intervention. There was a clear benefit from Japan's perspective. And from a U.S. perspective, there are a few benefits as well, such as weakness in yen was affecting broader weakness in other currencies or rising yields in the back end of the curve. But this time, Japan seems to have really asked for the help from the US. Hence, the market expectation is FX intervention was done. Dalian is still trading about 200-day moving average, even after the week payroll on Friday. The next action needs to be taken by policy changes by central bank.

3:52Patrick Coffey:Really, the story is intervention can only do so much. Ultimately, investors now ask whether the Bank of Japan itself needs to become more aggressive. Talk about what happened in trading today in Japan and where the market is in terms of pricing the next rate hike. Market is pricing roughly about 7th January and June hikes, which is we had the last hike in June. The next hike in SEP means hike is happening only after one meeting pause. Then thereafter, every three BOJ meetings, which is much faster than prior every half a year or every four BOJ meeting pace. The market is already pricing some sort of hike acceleration.

4:38I think the most focused scenario it can possibly go is hike every three months or every other meeting, which market is pricing about 40-50 % of the probability today.

4:50Patrick Coffey:And am I right in saying that because of the way that the board is set up in the Bank of Japan, it's unlikely that the hiking cycle will be any more than every three months? Do you want to explain that for our listeners? The Prime Minister, Takahichi, will assure pushback if BOJ goes to them and say they want to hike every meeting. She's a strong proponent of inflation, very famous. She thinks BOJ is a subsidiary of the government. And that's why the market never thinks BOJ can hike to neutral rate, which I think is well above 2%. Instead, the market thinks the terminal rate is actually lower than neutral rate.

5:36Patrick Coffey:Okay. And so talking about PM Takehichi, let's zoom out and think about the wider economy in Japan. Because the last time we focused on Japan on this podcast, it was the day after Takehichi's decisive victory at the polls. Her approval rating then was extremely high. It's still very high. What policies is she pursuing that's catching your client's attention? And how are those policies impacting markets? Takaichi is a strong proponent of reflation and she thinks the OJ is a subsidiary of the government. Those two have been the primary themes that the market have been focusing on. On day one, Takaichi's approval rating was very high, which has come off a bit, but still very high today.

6:22And the gap between Takaichi's approval rating and the ruling political parties, which is LDP's approval rating is still about 30 % today.

6:32Patrick Coffey:Which is very wide compared to the history. Which is very wide. And it's been about 10 months since her inauguration. What has changed is her thinking of how strongly she can go with. She has become more vocal about implementing fiscal stimulus because her approval rating has remained high. Okay, so her approval rating is very high. She's clearly very focused on fiscal expansion. talking about defense. She has this 370 trillion yen investment plan. She's talked about lower bats for food, refundable tax credits. There's lots of policies she's implementing. So if we think then about sitting here in a year's time and we're talking, what do you think the market will be saying about Japan that would sound surprising today?

7:19Patrick Coffey:You know, what are the themes that maybe are being missed by investors that you see some interesting trade ideas? I think the probability of, debt divergence in Japan is still underpriced. It's somewhat priced in, but rating agencies even saying Japan doesn't have any fiscal issues. For the next couple of years, debt to GDP ratio will continue coming off, not because Takaishi is doing a great job, but because of JGB redemption schedule, and because nominal GDP growth rate is higher than nominal rates. The expected path for Japan is interest payments to GDP ratio is currently 1.8 % today, which is going to be 5.5 % to 6 % in 2040, significantly higher.

8:10And we're going to have fewer population over the next 15 years or even longer time horizon. And senior ratio will increase from 30 % today to 35 % in 2040. There's a significant possibility of dead divergence happening in Japan sooner or later. it's not going to be under Takaichi's administration because of Jesuit redemption schedule and R-G or nominal growth rate is higher than nominal rates, not because Takaichi is doing a great job. So if we're ever taking over the Prime Minister post after Takaichi will be facing those issues in a couple years' time and that's, I think, when market realizes there is a significant higher divergence risk.

8:59Patrick Coffey:And how are clients thinking about trading that? In Japan, people usually want to have bare flattening positions in rates, but there's a limitation for flattening to be happening for two reasons. One is people never think BOJ can hike up to neutral rate. Camino rate will be always lower than neutral rate. Two, there is a debt divergence risk. They need some additional fiscal premium. I think significant flattening for any reasons is a fade. Okay, Taka, thank you so much for joining me on the podcast today. It's been great to chat. Great to be here. Thank you very much. So as the market in Japan closes and the market in London is about to open, the key message from this conversation, I think, is it's impossible to ignore Japan.

9:49Patrick Coffey:Whether it's the direction of the yen, the pace of the Bank of Japan's tightening schedule, the impact of fiscal policy, or the behavior of one of the world's largest pools of capital, developments in Japan increasingly shape conversations well beyond its borders. Thanks a lot for listening to The Barclays Brief. Do hit subscribe and we'll see you again next time.