Traders Underpricing Risk of Higher Japan Yields, Vanguard Says

As traders pile into wagers for an interest-rate hike from the Bank of Japan this month, they’re still missing the risk that Japanese interest rates will need to march even higher to quell inflation, according to Vanguard Group Inc. 

The yield on Japan’s two-year government debt has climbed above 1% in recent days to its highest level since 2008 as investors bet that BOJ officials led by Governor Kazuo Ueda will resume hiking benchmark borrowing costs at their Dec. 18-19 meeting. But after years of persistent easy monetary policy, the rate still remains far below Group-of-10 peers — even as inflation expectations in Japan are near their strongest mark in records going back to 2004.

“The market underestimates how high the neutral rate will need to go in Japan to relieve inflation pressures, so being underweight Japanese government bonds is the right one,” Roger Hallam, global head of rates at Vanguard, which manages $11 trillion in assets, said in an interview Thursday. “We still think that the Bank of Japan will continue to normalize and that it will hike in December.” 

Ueda said this week the neutral rate, a point where settings are deemed neither restrictive nor stimulative, is only estimated within a wide range. The Bank of Japan has previously said it lies somewhere between 1% and 2.5%. Its current policy rate is 0.50%.

Vanguard is underweight Japanese government bonds in the short to medium-part of the yield curve, relative to fund benchmarks, Hallam said. 

Bloomberg News reported Thursday that key members of Prime Minister Sanae Takaichi’s government won’t stand in the way of an interest-rate hike, prompting swaps traders to ramp up expectations of an increase. They’re now pricing around 22 basis points of tightening at the conclusion of the BOJ meeting on Dec. 19, compared to around 14 basis points just a week ago.

Vanguard’s expectations of BOJ rate hikes also underpin its stance that Japanese short-term rates will underperform longer-term ones, a view espoused in recent months by the firm and counterparts including Sumitomo Mitsui Trust Bank and T. Rowe Price International.

The Bank of Japan’s policy normalization “tends to flatten from the front-end outwards,” Hallam said. “Curve flatteners in between the belly and the long-end actually are reasonably attractive given the relative steepness of the yield curve.”

While the spread between five- and 30-year Japanese government debt narrowed some 35 basis points from September to October, that differential has recently pulled back, widening about 15 basis points from October lows. 

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