Manufacturing activity in Japan registered its weakest growth in almost two years, according to the Markit Purchasing Managers' Index for July. And the Japanese economy could face additional obstacles if the US proceeds with auto tariffs – transport-equipment makers are the second-largest component of the TOPIX index at 8.7%.
But we still believe that the Bank of Japan (BoJ) will move gradually toward reducing monetary stimulus, which in our view is likely to undermine 10-year Japanese government bonds (JGBs) and push the yen higher.
- The BoJ has expressed concern over the negative effects of ultra-easy money on the country's banks, since a flat yield curve crimps profits. Media reports that the BoJ may be looking to raise its zero yield target on 10-year JGBs, introduced in 2016, pushed the yield 8 basis points higher on Monday – the largest daily move in almost two years. While the exact timing of a move is hard to predict, we see it coming later this year.
- The gradual ebbing of the deflationary threat in Japan makes a policy shift less risky for the BoJ. Wage growth has accelerated, with average monthly cash earnings averaging 0.9% in the first five months of the year, up from 0.5% last year.
So we remain confident in our underweight position in 10-year JGBs versus cash. With the yield curve so flat, this is also a relatively cheap position to hold at a cost of around 8 basis points per year. The prospect of higher yields is also positive for the yen, which we overweight versus the Taiwan dollar. This position also provides some portfolio protection against risk-off moves in equities, since Japanese investors typically repatriate funds in such periods.
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