Edouard Desbonnets:
Hello, I'm Edouard Desbonnets, Senior Investment Strategist, Fixed Income at BNP Paribas Wealth Management. And today we will look at Japan, an economy that's been caught between a rock and a hard place. On the one hand, Japan has achieved full employment, a thriving corporate sector, and declining debt ratios, which are all positive signs for the economy. But on the other hand, the country is facing some significant headwinds, including inflation that is too high, declining real wages, and also a depreciating yen. So to discuss this, I'm joined by Guy Ertz, Deputy Global Chief Investment Officer at BNP Paribas Wealth Management. Hello, Guy.
Guy Ertz:
Hello.
Edouard Desbonnets:
So, Guy, let's start with the big picture. What can you tell us about the economy in Japan?
Guy Ertz:
Yes, well, as you mentioned, it's quite interesting that despite being close to full employment, Japan is actually, among the G7 countries, the country with definitely the low growth rate. We're talking about a growth rate below 1% for expected both in 2026 and in 2027. That has to do a lot with this potential growth linked to demographics. Also, on the demand side, we have some factors weighing on demand. We have the loss of purchasing power due to high inflation that plays a role. Also, higher interest rates. We'll talk about that more in detail in a minute. And still some negative impact from the US tariffs shock. Now, I just mentioned the interest rate component as the key driver or one of the very key drivers. So, let's go a bit more into detail on that. Edouard, what is the challenge of the Bank of Japan? And can we expect more rate hikes in the coming month?
Edouard Desbonnets:
We actually do because, yes, inflation is too high in Japan. And the mandate of the Bank of Japan is to maintain price stability, so core inflation at around 2%. So, since inflation is too high and does not show a downward trend yet, or at least not fast enough, then we do expect two more rate hikes this year, and also another one for the year after, 2027. And we think that the policy rate will therefore reach 1.25% in December this year and 1.5% next year. That will be the terminal rate, so the neutral rate for us. Markets are actually pricing fewer moves than us. So, we think there is a risk that the Bank of Japan will be more hawkish than expected.
Guy Ertz:
Now, this is about short-term rates. We've also seen long-term rates, the bond yields rising quite a lot. So, do you think everything is priced now, or could we even see the yields moving higher?
Edouard Desbonnets:
Yes, we had massive moves in rates, about 60 basis points higher for short-term yields last year. About 100 basis points higher for long-term yields last year. I'm talking about the 10-year yield, but also the 30-year yields. They were both up about 100 basis points last year. So, we're more or less at our target for the 2-year yield and the 10-year yield. Those were very big moves that were driven by the central bank. You know, it's been hiking rates and also trimming bond purchases, but also driven by the big fiscal stimulus with about half of that financed through new bond issuance.
For now, I want to point out that higher yields do create some effects on the market. And the first one is that the classic carry trade is actually losing its appeal. You know that investors used to borrow in yen at near zero rates to fund higher yielding assets abroad. But now, funding rates sit near 1% and hedging costs have risen as well. So, the profit margins have been squeezed. Another effect is that those rising bond yields mean that Japanese life insurers now have weaker balance sheets with billions of unrealised losses. And the last effect is about capital repatriation. And we think that will be a phenomenon that will actually increase this year. You know that for years, Japanese institutions have parked billions abroad because domestic rates were close to zero. And with yields now being positive, all those big investors, I'm talking about banks, insurers, and pension funds, they're all likely to bring a portion of capital home. So, there will be billions of capital repatriated to Japan.
But it will be a slow process. It will be a slow process because those investors, you tend to hold bonds to maturity. And there will still be some investors that will continue investing abroad, like hedge funds. So, yes, a slow process. But the direction is clear that Japanese investors will be less and less the marginal buyers of US and European bonds. And that's a structural headwind for global bond markets. So, Guy, we've discussed about the macro. We have discussed about central bank and rates. What about the yen? What is our outlook for the yen?
Guy Ertz:
Yes, well, the key driver for the exchange rate, or one of the key drivers at least, is the interest rate differential. And we've been mentioning the outlook for the Bank of Japan. The central bank in the US will be cutting rates further, we think. And the Bank of Japan will be increasing rates. So, we see here a potential for the interest rate differential to be moving in favour of the yen. And that would be a driver of a rebound in the Japanese currency, an appreciation. We do, however, see a limited potential of appreciation. Because with the new government and the new prime minister, we are expecting here more fiscal stimulus and also more debt. And that could be limiting the upside for the currency. So, very practically speaking, we're looking for a 3-month target against the dollar. So, in terms of one dollar of 152 and the value of the dollar in 12 months at 148, and that compares to roughly 156 today, January 5th.
Edouard Desbonnets:
All right. So, to sum up, Japan's labour market and corporate sector actually remain solid. But inflation still runs above target. And we expect the Bank of Japan to continue hiking rates gradually and towards 1.5% in 2027. The rise of bond yields will cause some yen carry trade positions to unwind. And also, a gradual shift of capital returning to Japan. And regarding the yen, we do expect a moderate appreciation of the yen.
Thank you for listening. If you enjoyed the podcast, please like, share and subscribe on Apple Podcasts, Podcast Addict or Spotify. And for more research, please visit the BNP Paribas Wealth Management website. Thank you.
Guy Ertz:
Thank you. Goodbye.