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Japanese Economy: Hello Japan's R star: What is Japan's natural rate of interest?

The natural rate of interest, understood as the real short-term rate level that is neither inflationary nor deflationary, is key in determining the terminal point of the BoJ's rate hikes.

We estimate Japan's natural interest rate from the well-known Laubach and Williams model (2003). As this model does not assume sustained cost-push shocks, we consider how Japan's estimated natural interest rate would change if the model is revised in light of the persistent cost-push shocks in the nation at present.

US Fixed Income: Bonds to gain on an asymmetric rate profile linked to the inflection in US macro data

Macro View: Given the growing underlying cracks in the jobs data, the burden that higher rates are having on the margin (for lower-income households and small businesses, CRE losses at the Banks, and even larger corporates in the high yield sector can get pressured soon), it’s a matter of time before macro conditions worsen. 

On the inflation front, there was a slight improvement in the CPI indices in April, breaking a trend of hotter readings seen during 1Q24. Its possible that the seasonal adjustments that took place during Q1 were outsized and led to a bigger bump up in those monthly readings. The majority of items in the latest CPI report have an annualized inflation reading around 2%. Meanwhile the owners-equivalent rent (OER) and shelter costs are still stubbornly high and lagging the declines in actual market-based rent inflation trends. The combination of improving seasonals and an eventual catch-up towards lower inflation readings from OER should pull CPI lower, in our view. 

On the growth front, the April jobs report was also one of the weakest releases of late. Not only was the headline number for the establishment survey sub 200k (at 175k) a large portion of the job gains came from one industry and from low paying jobs. And the household survey showed only a 25k job gain with a rise in the unemployment rate towards 3.9% (close to the 4% threshold that will likely capture the Fed’s attention). The workweek also shrunk again and wages were below economist expectations. In general, the April NFP encapsulated the cracks under the surface for labour markets. This weakness in the jobs market is translating into a decline in consumer confidence. This dour sentiment is being picked up in the earning news from many retailers. Net, consumers have burnt thru saving and maxed out on credit, hence weak retail sales.

Market view: Our base case remains for 100-125bps total rate cuts in 2024, concentrated in the 2nd half. And there is still a path towards the first cut being delivered in July. Such a move would be a down-payment on normalization, allowing the Fed to gauge data in the summer, discuss the neutral rate at the August Jackson Hole event and avoid the 1st cut around the election. We also assume Q2 data softens and risk assets rollover, giving the Fed a green light to cut. They may skip Sept, but given our outlook, if they skip Sept subsequent cuts may need to come as -50bp clips.

FX Outlook

The US dollar has weakened since the last release of the Global Markets Monthly (23rd April) with the primary catalysts for the move lower the FOMC meeting on 1st May; the US jobs data on 3rd May and the then the US CPI data on 15th May have combined to send yields lower and remove the upward momentum for the US dollar. The MoF in Japan is also suspected of intervening to sell the US dollar for the yen after USD/JPY broke higher, hitting the 160-level briefly. We maintain that there is ample time for the Fed to still lower the fed funds rate on three occasions and by 75bps, which is not fully priced and would therefore act as a catalyst for further US dollar depreciation. The US dollar (DXY) has weakened by 1.0% since the last release and we see scope for a further modest decline by year-end. An improving global backdrop will help as well with economic data from Europe signalling better growth ahead while China has taken further measures to try and restore confidence to the real estate sector.

USD/JPY - Neutral Bias - 148.00-162.00

EUR/USD - Neutral Bias - 1.0500-1.1000

USD/CNY - Neutral Bias - 7.1800–7.2800

 

KEY RISK FACTORS IN THE MONTH AHEAD

• The main upside risk for USD/JPY would be if the Fed strikes a more hawkish tone at the June FOMC meeting by signaling that rates may not need to be cut this year and/or financial market conditions remain favourable for JPY-funded carry trades. The JPY continues to weaken but at a gradual pace that does not trigger another bout of intervention from Japan. In contrast, the main downside risk for USD/JPY would be if evidence emerges of a sharper slowdown in the US labour market and/or US inflation encouraging the US rate market to price back in more/faster Fed rate cuts in the year ahead.
• The main upside risks for EUR/USD are: i) if the US economy and/or labour weakens sharply bringing forward Fed rate cut expectations and encouraging a weaker USD, ii) the recent pick-up in US inflation proves to be just a temporary bump in the road and slower inflation resumes in the coming months, and iii) if the euro-zone economy picks up more strongly than expected as the headwinds from higher inflation fades. In contrast, the main downside risks for EUR/USD are: i) the ECB becomes more concerned by downside inflation risks and cuts rates more quickly, ii) the Fed delays cutting rates this year as inflation contuse to prove more persistent and heightened US political risks lift uncertainty over outlook, and iii) the conflict in the Middle East escalates further and triggers another oil price shock.
• For USD/CNY, we see both upside and downside risks on the currency. Further upside can be positive details of currently rolled out real estate policies and additional policy approaches to revitalize China’s economic recovery. Downside could come from frictions between United States and China. Although the newly announced tariff hike on USD18 billion imports from China will not have much material impact, but with only 6 month till US election, the risk of escalating “de-China” action or proposal could pressure on China and the currency.

European Credit

After the short lived early January spread widening credit markets performed particularly well and credit spreads are now at 2 year tights in IG. The overall EUR corporate IG index has rallied relentlessly in the past months and is now at z spread 109bp, down from z165bp in October 2023 and z146bp in early January 2024.  Overall credit yields have moved more laterally since central banks from ECB to the FED have not started any rate cuts yet and the timing of those, especially in USD is still quite uncertain. The credit markets have tightened despite the elevated rates volatility.

The benign economic backdrop also remains very supportive for IG credit. The recent oil prices have been in the middle of a band at around USD78 and other risk indicators such as Bund-BTP spread has now rallied to 2 year tights of 129bp,from 205bp in October 23.

We maintain our view that IG credit continues to be an attractive area for investors, given the mixture of strong underlying fundamentals of the bulk of the members of the index and overall still attractive yield levels, albeit less than in 2023. We expect credit spreads to remain resilient on the back of strong technical demand at current attractive yields. IG credit looks like an attractive market for carry at this point, with some potential for even further spread tightening, albeit in a generally more lateral way.

The geopolitical situation remains complicated with the conflicts in Ukraine and Gaza as well as the security in the Red Sea and potential volatility in tensions in Taiwan. Despite no signs of appeasement these remain a cause of uncertainty, albeit the market has grown used to it. China’s domestic economic uncertainties, add to the overall volatility in risk sentiment. But also here overall sentiment has remained stable.

As a result,  cash spreads have rallied significantly but also synthetic indices are not showing any signs of respite. Since early January the XO tightened almost 64bps to 289bps. Pre-invasion of Ukraine XO was in the 320 area. Main is  also 14bps tighter at 51bps since the start of January (October wides of 90bps).