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Pimco Dropping Linkers Calls Time on Abenomics Inflation Target

Aeon Mall Makuhari Shintoshin Shopping Mall
Customers walk through the Aeon Mall Makuhari Shintoshin shopping mall, operated by Aeon Mall Co., in Chiba. Consumer prices excluding fresh food increased 1.2 percent in November from a year earlier, the most in five years. Photographer: Kiyoshi Ota/Bloomberg

Pacific Investment Management Co. stopped favoring Japanese government bonds that benefit from consumer price gains as it predicts Abenomics won’t generate 2 percent inflation.

Tomoya Masanao, head of portfolio management for Japan at the operator of the world’s biggest bond fund, said a year ago that linkers were a good play, citing Prime Minister Shinzo Abe’s plans for wide-ranging stimulus measures to stoke economic growth. Since then, Japan’s inflation-indexed government bonds returned 4.2 percent, almost fivefold the 0.9 percent gain on non-indexed JGBs on similar maturities, Bank of America Merrill Lynch data show.

“While we thought Japanese linkers were very attractive investments between late 2012 to 2013, they are not at current levels,” Masanao said in an interview in Tokyo on Jan. 17. “Back then, there were still plenty of upsides, even if we didn’t think inflation rate was going to increase to as much as 2 percent on average.”

The yield gap between 10-year nominal government bonds and inflation-linked debt rose to 1.12 percentage points on Jan. 17, the highest since October. The breakeven rate, which signals bond investors’ expectations of future inflation, would be around 0.7 points if the impact of the two-stage doubling of sales tax to 10 percent from April is excluded, according to Masanao.

Consumer prices excluding fresh food increased 1.2 percent in November from a year earlier, the most in five years. The Bank of Japan more than doubled monthly bond buying last April to exceed 7 trillion yen ($67 billion) and promised to more than double the monetary base, targeting annual inflation of 2 percent within two years to snap Japan’s decades of deflation.

Challenges Remain

There is still a risk Japan will fall back into deflation as securing an evironment for price increases remains a challenge, Economy Minister Akira Amari told reporters in Tokyo today. The country is moving smoothly toward the 2 percent target, Amari said.

Policy makers are likely to ease further if growth slows more than forecast after the sales levy increase, Masanao said.

The Ministry of Finance sold 300 billion yen of 0.1 percent, 10-year inflation-linked notes on Jan. 9 at 105.90 yen, exceeding the median estimate of 105.65 yen in a Bloomberg News survey. Investors offered to buy 2.87 times the securities offered, down from a 3.74 bid-to-cover ratio at the prior auction on Oct. 8.

Linker issuance, which resumed in October after a five-year halt, will increase by at least 1 trillion yen to a total of 1.6 trillion yen in the fiscal year starting April 1, the ministry said last month.

Not Cheap

“Japanese linkers aren’t necessarily cheap if we take into account their liquidity -- investors should demand more risk premium,” said Masanao.

Japan’s 124 trillion yen Government Pension Investment Fund plans to buy domestic linkers in the fiscal year starting April 1. GPIF was advised last year by an expert panel to reduce holdings of JGBs to put more money into higher-yielding assets.

“The best destination for Abenomics would be sustainable real growth around 2 percent and nominal growth of 3-4 percent,” Masanao said, referring to Abe’s economic policy. He added that neither of these are likely to be achieved this year.

“The Bank of Japan won’t be at the stage to discuss exit strategy,” Masanao said. “The greatest dilemma for the BOJ exiting unprecedented monetary easing, would be if we see inflation accelerate as they try to forcefully repress nominal yields or if a surge in bond yields trigger a fiscal crisis.”

Pimco is focusing on Japanese government debt maturing in 20 years that is “relatively cheap” in the super-long space and shunning “extremely expensive” 10-year bonds, he said.

Targeting Longer Bonds

The 10-year yield was at 0.67 percent today, the lowest globally. The benchmark rate swung between a record low 0.315 percent on April 5, the day after the central bank unveiled its stimulus, to as high as 1 percent in May. The spread with 20-year debt has narrowed to 86 basis points from as much as 1.05 percentage points in January 2013.

“The current 10-year yield is low relative to the economic fundamentals because the BOJ’s QQE has reduced the risk premium,” said Masanao, referring to quantitative and qualitative monetary easing. “QQE has been a powerful supporter for the JGB market and will continue to be so.”

“Before Abenomics, the Japanese economy was in deflationary equilibrium. Natural rate of interest, or potential growth rate, was lower than real rates under deflationary expectation, and therefore the private sector rationally chose to save rather than invest,” he said. “Now, with Abenomics experiments, we see a somehow higher, if still not a major, future risk of fiscal crisis.”

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