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10yr JGB yield upside prospects amid terminal rate overshoot speculation?

10yr JGB yield sails past key 1.3% level amid speculation of BoJ terminal rate exceeding market expectations
We calculated future 10yr JGB yield using estimation model that incorporates policy rate expectations, UST yields, economic/price conditions, and stock effect
If market prices in terminal rate above 1.0%, 10yr JGB yield could top 1.5%.

US Fixed Income: Until a positive or negative catalyst surfaces, bonds remain stuck in a range

Macro View: A long standing view that we have shared is that the underlying labor market dynamics have been over stated and trending softer for some time now. While December’s NFP report was shockingly stronger than expected, January’s report was mixed in comparison. Headline NFP missed expectations at 143K, while November and December were revised up by 100K in total. Government and healthcare hiring remained strong and "other" industries, including professional and business services, showed relatively strong monthly growth. In addition, the weather effects model from San Francisco Fed suggests that extreme cold temperatures and snowstorms dragged growth down by ~80K. Notably, the CES benchmark revision reflected a revision of -598k in March 2024 vs the -818k preliminary estimate. Although this was a slight improvement its consistent with the notion that jobs data has been historically overstated. Meanwhile the birth-death model was revised by -88K (the birth-death model adjustment broken from trend and was negative versus historically being revised up during prior adjustment in the past). The unemployment rate dropped to 4.0% due to updates to population controls intended to better reflect recent immigration flows. We do not expect this improvement in the unemployment rate to last given the federal hiring freeze (and reduced staffing goals) as well as less immigration trends ahead.

On the inflation front, while CPI has generally been on a downward path for the past few years, January saw another upside surprise, with headline and core CPI accelerating 0.5% and 0.4%, respectively (much higher than the Bloomberg consensus expectations of 0.3% for both measures). The shelter component saw a 0.3% gain in owner’s equivalent rent (OER) and a slight uptick in rent to 0.4%. Transportation services (once again driven by higher auto insurance costs) were a significant contributor in January, as were used auto prices. The used auto price adjustment seemed more than market-based measures would have suggested. And the insurance hikes continue to confound economists and their seasonal model adjustments. Overall, the higher than expected CPI reading was driven more so by services prices than goods prices. Supercore (core services ex housing) CPI was up a big 0.76% m/m, driven by transportation and recreation services. We note the January core PCE reading may not be as hot as the CPI was, given that many of the PPI components that feed into core PCE (financial and healthcare services) came in softer in January.

Fed view: As expected, the Fed left rates unchanged at its January FOMC meeting, the first skip in the latest normalization cycle. The overarching messaging from the press conference was that policy is less restrictive than it was at peak rates and the Fed does not need to be in a hurry to adjust interest rates lower. Given the hawkish-leaning Fed commentary, we continue to expect a prolonged pause before rate cuts resume later this year, with updates on the QT process taking place in early summer.

DC Views: Fundamentals and the Fed continue to take a back seat. The markets are focused instead on the ongoing updates coming out of the Trump administration. For now, the markets have not over-reacted (in either direction) and are optimistic on what lies ahead in regards to passing the budget, the debt ceiling and tax cut extensions. The risk is the congressional budget process (Figure 1) gets bumpier from here on out.

Market Implications: We would not characterize the current market environment as a period of complacency per-se but instead a world of low conviction and linger confusion. Such a backdrop is leading to a lower implied vol even though most markets continue to trade in broader ranges (that can be volatile but overall limited). We do not think US macro data on its own will be enough to break bond markets out of the range.

FX Outlook

The US dollar has failed to strengthen at the start of Trump’s second term giving back some of the strong gains recorded following last year’s US election. There has been some initial relief that President Trump’s tariff plans have not yet proven to be as disruptive as feared for global trade and the economy although it is still early days. Trade policy uncertainty is set to remain elevated while plans for reciprocal tariffs are finalized in the coming months. Reciprocal tariffs have the potential be implemented more widely and be more disruptive in size after incorporating non-tariff barriers and other taxes such as VAT. As a result, we are not yet willing to throw in the towel for our call for a stronger US dollar. The Fed’s cautious policy stance over delivering further rate cuts should remain supportive for the US dollar as well although the most hawkish major central bank is still the BoJ whose plans for further rate hikes are encouraging the yen to rebound further.

USD/JPY - Bearish Bias - 145.00-157.00

EUR/USD - Bearish Bias- 1.0100-1.0800

USD/CNY - Bullish Bias- 7.1500–7.3500

KEY RISK FACTORS IN THE MONTH AHEAD

• The main upside risk for USD/JPY in the month ahead would be if US yields move back towards year to date highs. Strong US activity and/or inflation data alongside a more hawkish reassessment of the Trump’s tariff plans could reinforce expectations that the Fed does not need to cut rates further this year. Alternatively, the BoJ could start to dampen their hawkish policy guidance if JGB yields keep moving sharply higher triggering a reversal of recent yen gains. A keynote speech from BoJ Deputy Governor Uchida on 5th March will be watched closely to see if there is any paring back of hawkish rhetoric.
• The main upside risks for EUR/USD include: i) a quick peace deal to bring the conflict to an end in Ukraine including comments from European officials indicating a willingness to reopen gas flows from Russia, and ii) the ECB signals more caution over cutting rates again after delivering another 25bps cut in March.
• The main upside risk for USD/CNY would be any further escalation from Trump’s tariffs on imports from not only China, but also from other countries. If reciprocal tariff is found to be too hard to implement and a blanket tariff is imposed instead, it would likely lead to a stronger USD against most currencies. For China specifically, there is a risk of Trump administration imposing additional tariff based on any perceived unfair taxes, non-tariff barriers and etc from China. The downside risk for USD/CNY includes a stronger-than-expected fiscal stimulus to be unveiled in March NPC.