Anders Faergemann  20:38

Welcome to this PineBridge podcast, where today we will be discussing global rates and implications for the US dollar. But more specifically, we'll dig a bit deeper into the situation in Japan and the rates volatility we've seen in recent months and aim to identify some new trends post-election. I am Anders Faergemann, Head of Global Sovereigns and Economics. With me, as usual, is Hani Redha, Head of Strategy and Research for Global Multi-Asset and today we also have a guest on the podcast to help us distill the signal from the noise in the Japanese rates market and so I'm happy to welcome Omar Slim. Omar is Portfolio Manager and Co-Head of Asia Fixed Income. Welcome Omar.

Omar Slim 01:22

Good to be with you. Thank you, Anders.

Anders Faergemann  01:25

First, let me turn to you Hani for an update on global macro.

Hani Redha  01:33

Sure thing, Anders, so look, I'd say that overall data is very much on track with what we've been expecting in terms of a re-acceleration of growth and inflation coming into the first half of 2026 and very much a global re-acceleration in Europe. For example, we're really seeing German spending is picking up as expected, mostly in defense, but also in infrastructure, and then in the US, I'm seeing signs of a clear manufacturing upcycle. We see this in PMIs, we see it in manufacturing and industrial production data, and also in channel checks, in freight volumes and pricing, all suggesting that we are seeing goods-based industrial cycle taking hold. 

But I'd also say there's a bit of a change in the mix, in that technology capex on data centers and AI are starting to decelerate. The growth rates are still very high but starting to decelerate from the rates that we saw last year. So, that is an interesting development, and we think that overall, it makes the US a little less exceptional, given that this is a global re-acceleration, not only a US one, and that will have implications for the dollar.

Anders Faergemann  03:11

Thanks Hani. Yeah, that economic resilience you're describing, it's obviously important for the dollar, but it's also important for risk markets and volatility overall. And we have seen volatility creeping higher in some markets outside fixed income, but it's not long ago we saw heavy volatility in the Japanese rate market, JGBs, with some spillover effect to long end in other bond markets. 

Yet, the market appears to have stabilized in February, in tandem with Takaichi's landslide victory in the snap election, alongside two-year rates moving above 1%. Let's explore if this stabilization is sustainable. But before we go into the rates discussion, Hani, can I ask you to give us an update or paint a picture of the underlying fundamentals in Japan?

Hani Redha  04:11

Sure, Anders, yeah,  Japan is a fascinating experiment for markets. You know, we've never had such a degree of aging in a modern society. So how growth and inflation dynamics unfold, and also how the politics and policy mix shifts is really uncharted territory. 

I'd say structurally, it's still going to be very challenging for Japan to generate real growth, given that the pace of aging is actually going to intensify over the next few years, but we do see that a regime shift has happened when it comes to inflation. It seems that Japan has broken out of decade long deflationary mindset, outright deflation, and so nominal GDP has now broken out to a higher baseline level, which I think is very interesting and a clear change. 

But I see this as more of a 1% inflation type of economy, rather than 2% which is still the target. Most of the inflation has been food and energy, and as those fade, we'll be left with wages and services inflation that will hover closer to 1%, which is still not bad, given the dire situation we were in a few years ago, but not really able to maintain it as a target, I believe. 

And cyclically, we're already seeing clear signs that growth and inflation are rolling over. We see it in inflation data, which peaked above 4% but it's now already at target and then actually heading lower. And we also see it in labor markets, where job openings have rolled over as well. So I think we see the Bank of Japan continuing with its rate hikes, but perhaps less than the market anticipates, but away from those fundamentals. Omar, maybe I can bring you in here. I know you've been spending time in Japan recently and have spoken to various asset owners and market participants. How do you see this backdrop in Japan? What are you hearing and what are your views on the direction for JGBs from here?

Omar  06:34

Yeah, thank you, Hani. First, let me just say that I would echo what you just said about the regime change in Japan when it comes to inflation in particular, I think that took some time in the beginning for people to believe in it, frankly, including the policymakers in Japan, particularly when they focus on what they call the homegrown inflation, which we had started to see some of it, particularly over the past few quarters. 

So you call it the regime change, and I think that is an appropriate term from my perspective, because it is the first time in decades that we see some inflation in Japan and, more importantly, homegrown inflation. In terms of technicals, there's a lot of talk about technicals, but I think the chat around technicals tend to be focused on the longer and JGB in particular. And here I would say that the technicals have been generally weak. 

There's a few reasons for that. One is the historical and natural buyers of the long end JGBs have been the local Japanese buyers, and particularly trust banks, pension plans and more specifically insurance. And driven by multitude of change, we saw some changes in terms of them anchoring that part of the curve, which led to quite a bit of volatility. I think a lot of people talk about volatility over the past year  in the rates market, but if you actually look at it, we haven't seen substantial volatility in most rates market. 30 year, for instance, for the US Treasuries, over the past year, we've seen them trade in a range of roughly about 75 basis points or so. 

If you compare that to the JGBs longer end, the 30 years, we saw them trading in the range of 160-170 basis points. That's a significant divergence in terms of how the JGBs were trading. And again, I think the insurance segment has been a bit less supportive for a number of reasons, including the asset mix. They have bought quite a bit more non-JPY and they have expanded outside of Japan. And that was an intentional policy, frankly, from the Bank of Japan for some time, going back to Abenomics and the Three Arrows, if you might recall. 

And also, there has been some changes in terms of the regulatory picture in Japan, which will come into effect later this month. We're recording this early March, so I think this will take effect in the first of April, which is the first month in terms of the fiscal new fiscal year for Japan, particularly when it comes to economics, obviously, ratios and so on. So, the technical picture is much, much different than it used to be 15-20, years ago. And you can feel it in terms of volatility in the JGBs, which I think will continue.

Hani Redha  09:47

Great. Omar, thank you that, I guess my follow-on question would be in terms of what you think the Bank of Japan does here, in terms of further hikes, the market has quite a few priced in, I would take the under on that, as they would say. But what do you think? What's your view on the policy rate?

Omar Slim  10:11

I think the Bank of Japan messaging has been that they are normalizing monetary policy, as opposed to turning much more hawkish, or even more hawkish, and I do think that they are itching to go and itching to normalize. Having said that, and I think you alluded to that in your introductory comments, we saw inflationary pressure dissipating a little bit over the past few months. That is partly because of the subsidies that were announced by the Takaichi administration. So part of it is dislocations and temporary. However, there's no question that the inflation pressure has subsided. 

So, my view is that the Bank of Japan will continue to hike, probably, I think, another one in the next quarter or two, and then after that it becomes slightly academic, but I think they would like to get to kind of low 1% in terms of the neutral rate. But they're not in a hurry and I think the new administration would welcome the Bank of Japan not being in a hurry at this point.

Hani Redha  11:25

Very good. And Anders, I'll bring you in here and say that, in our framework, we would say that if we're right with those number of hikes, and if inflation struggles to get to that 2% on a sustainable basis, then we're looking at 10 year JGBs closer to 2% rather than anything materially above that. But what's your sense of where we go from here?

Anders Faergemann  11:53

Yeah, a lot hinges on the inflation outlook. But as you pointed out Hani, we are getting more comfortable with a regime shift in terms of reflation, so staying above 1% which is significant. And then if we take into account the debt side of things and the interest burden possibly being lower than the market gives the policy makers credit for, I do believe we can get some more stability in the JGB market, especially in the second half of the year. We haven't discussed the Japanese yen. Anything you want to mention there, Hani.

Hani Redha  12:41

Yeah, I think that I'd say overall, we've had a bit of a perfect storm in Japan in terms of inflation that surprised us all with a lag compared to the rest of the world, and we've had a lot of political uncertainty. And all of this led to this very weak yen, and a very strong trend in that direction. I think all of those things are dissipating. And so our forecast for the yen, which is actually materially still stronger than where we are now, I think that still makes sense to me. But what's your view?

Anders Faergemann  13:22

Yeah, I share that view, and it is out of consensus, but I think we saw a few rate checks before the election, which was unexpected and very rare, but again, shows the desire by the authorities to maintain stability, both in the dollar yen market, but also in the rates market. So as we've talked about, the volatility we've seen in the JGBs has been exported to the Treasury market as well, and maybe we can get in there in terms of our forecast and changes from the investment meetings. 

Just to quickly summarize, we went through three major changes. One, we adjusted the number of Fed policy cuts from one to three cuts over the next 12 months. As a consequence of that, we also lowered our 10-year treasury forecast from four and a quarter to 4%. The second change was we decided to remove the remaining rate cut we penciled in for the ECB, probably not that controversial anymore. And then finally, the combination of the two would flip the script on the US dollar and now see the path of least resistance for the US dollar as softer over the next 12 months. 

And what I would say Hani what changed that was [Trump] naming Kevin Warsh [as his nominee] to replace Jerome Powell as the next Fed chair. That’s definitely clearly changed the Fed's policy stance. So, while we accept Warsh only has one vote on the board, we also need to acknowledge that to win the job also has committed to delivering more rate cuts and lowering yields.

Anders Faergemann  15:30

Where does that leave us Hani in terms of the dollar, I'll bring you in, but just to summarize, we've been more bullish on the dollar coming into the year built on several factors, including the growth differential. We expected a re-acceleration in the US and now, as you say, we're seeing a broadening of that global upswing, and so that could potentially curtail some of the upside in the dollar, considering the dollar smile, and then, as you alluded to, the Euro component should be stronger from here. So we've changed our euro / dollar forecast from 115 to 119. I haven't mentioned the US exceptionalism you alluded to it earlier. What are your thoughts on that and the recent volatility we've seen in AI and software and the US equity markets.

Hani Redha  16:42

Anders, I'd say that the global picture is really what's changed more so than within the US. But as you say, AI and technology, which has been a dominant force. that has had a macro effect, not just, in terms of its own sector, or just within equities, it's really become so large and dominant that it's a macro driver and now is in a kind of digestion phase and leading to a lot of disruption, which doesn't lift all boats at the same time, and so that makes the US a little less dominant in terms of growth driver, and I'd say that's what's leading us to expect a softer dollar than we were previously anticipating. 

That said, I see this as more of a temporary setup, one worth positioning for, for sure. But I do expect that dominance of technology in the US to reassert itself, perhaps later in the year and next year. But for now, I would say that the soft dollar as a result of a broadening of growth beyond a single sector and a single country, is why we've changed our forecast.

Anders Faergemann  18:14

Thanks, Hani and clearly, a year of two halves, but that's all very clear and actionable. And thank you, Omar, for joining us today and sharing your insights. What I would say is the Japanese bond market will continue to be a focus for us as we do see a regime change forming on the macro front, perhaps more structurally than cyclically.  We need to be patient, especially on the supply and demand front, and wait for the technical factors to provide similar optimism. Valuations are attractive, and we can see stability forming and as we talked about, we have an out of consensus yen appreciation in our forecast, so a market we do monitor vigilantly. With that, we'll be back next month. For more information, please visit pinebridge.com. Till next time, thanks for listening.

ENDS