In several periods over the past decade, many sophisticated investors sought to profit from a rise in Japanese interest rates. Given the perpetually slow growth, combined with an ever-increasing long-term debt burden, they believed that the economic fundamentals did not support the lowest borrowing rates in the world. However, very few of these investors were ever able to profit from their economic thesis.
Today, we believe that if Shinzo Abe’s plan for the reflation of the Japanese economy is successful, the value of the yen will weaken materially, and interest rates may begin to rise in response to his policies. As a result, we believe there are several factors that may contribute to a rise in Japanese interest rates. Most notably, a rise in inflation and inflation expectations may finally spur the Japanese economy while at the same time supporting an increase in longer-term Japanese interest rates.
Why Should Investors Settle for a Decline in Purchasing Power?
Decades of deflation in Japan had the effect of incentivizing savings over consumption. If investors believed that prices would continue to drop in the future, their incentive to make a purchase today was lowered. This had the impact of not only causing a drag on economic growth, it also kept government borrowing costs low. However, this multi-year trend has recently been reversed. In our view, this byproduct of Abenomics may not only be positive for Japan’s economic growth but also result in a significant shift in investors’ asset allocation decisions. As shown in the chart below, deflation has the effect of boosting real interest rates, rewarding savings and disincentivizing consumption. Recently, the Bank of Japan has been successful in generating positive rates of inflation. As a result of this change, the real rates of Japanese five-year bonds have actually turned negative, implying that investors are actually losing future purchasing power by holding Japanese five-year bonds.
Drastic Change in Inflation Expectations in Japan (05/31/2009–10/31/2013)
For definitions of terms in the chart, please visit our Glossary.