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As Japan hits negative inflation, why should traders care about Japanese CPI?

The Japanese core inflation rate has been steadily declining since May 2014 when it stood at 3.4%. By July 2015 it had sharply contracted, posting a flat reading, and today’s release reveals a drop into negative territory at -0.1%. Where to next for Japanese CPI?

Japan staring at a contractionary economy

The rate of inflation is an important economic indicator for a country’s growth prospects. Many people associate inflation with something negative, but this is a skewed perception of the importance of a healthy increase in prices. In the period from 1958-2015 Japan’s inflation rate averaged 3.14%. At the height of the global financial crisis, the Japanese economy contracted, and the rate of inflation hit -2.52%.

This reflects the onset of a deflationary cycle which is especially dangerous to a nation’s growth prospects. The problem with negative inflation is that it has the potential to lead to sustained deflation. This comes with all sorts of challenges in the form of delayed purchases of big ticket items like homes, vehicles, equipment etc.

The categories that comprise the largest percentage of the Consumer Price Index (CPI) in Japan include housing, food, culture and recreation, transport, and communications. Other minor items include medical care, clothing, lights and water, furniture, and household utensils.

The latest update for Japanese core CPI (excluding fresh food) came this morning, revealing a year-on-year rate of inflation for August of -0.1%, the first negative reading since April 2013. The main drivers of declining inflation rates are energy costs, housing and travel costs, and telecommunication. As the price of Brent crude oil declines, it drags down the costs of many other sectors including manufacturing, retail operations and general wage growth.

All eyes on Haruhiko Kuroda

There is a growing consensus among investors that the Bank of Japan will increase purchases of ‘super-long’ bonds. Just recently, five-year Treasury notes were auctioned, and they fetched the greatest demand in six months to date. The bond market is expecting the BoJ Governor, Haruhiko Kuroda, to enact further stimulus measures to kick-start the ailing Japanese economy.

Japanese traders are rightly concerned about equities markets as a result of structural weakness in China. The yield on long-term debt in Japan has fallen more rapidly than short-term securities. Plus, there are increasing calls for the Bank of Japan to enact stimulus policies, as Japan struggles to meet its 2% inflation target.

There have been increasing returns on Japanese government bonds since the Chinese currency devaluation of 2%. The Nikkei 225 index struggled to post positive gains for the year, after rallying briefly of late. To date, the Nikkei 225 index has a one-year return of 12.56%, but its year-to-date return is just 3.55%. The Tokyo Stock Exchange has a one-year return of 11.86%, but with a year-to-date return of 3.90%. These figures reflect the enormous pressures placed on the Japanese economy as a result of the Chinese equities meltdown which saw $8 trillion wiped off global markets.

The Bank of Japan is snapping up government bonds

The Bank of Japan has been feverishly buying up as many government bonds as it can. The quantitative easing policy has flooded the market with money, but investors remain deeply concerned about the market’s functionality. According to analysts, the greatest likelihood of action by the Bank of Japan is in October 2015. It is then that a possible rate hike may be considered. Presently Japan has a 0% interest rate.

However an even greater number of sceptics remain convinced that the Bank of Japan is unlikely to enact policies. The yield on 10-year bonds in Japan is just 0.36%. Haruhiko is convinced that by April 2016 Japan will hit its inflation target of 2%. One of the other factors holding Japanese economic performance back is export weakness. Even with China as its major trading partner, the BoJ Governor remains convinced that Japanese exports too will strengthen.

Instead the BoJ has kept to its word of increasing the money supply at a rate of ¥80 trillion per annum. Global volatility in bond markets is especially high in Germany and the US, but in Japan this is not the case. The government bond futures in Japan averaged 2.69 – significantly lower than the one-year average volatility of 2.90.

Caution is the order of the day for Japanese equities

Even with all the upbeat commentary from the central bank governor, sceptics abound. The fact of the matter is that one cannot discount the negative impact the world’s second-largest economy is having on global equities, demand and ongoing economic weakness. That China is struggling to stabilise its markets is having a disastrous impact around the world. The Fed decision not to hike interest rates was largely based on China weakness.

For now the government’s policy – dubbed Abenomics – appears to have been working with regard to quantitative easing. Deflation is being combated head-on, but recessionary fears are real. According to many economists, the problem lies in the fact that monetary and fiscal policies have divergent effects on the economy. Increased taxation and monetary stimulus are simply at odds with one another.

That the Bank of Japan, the Bank of England and the Federal Reserve Bank are all targeting 2% inflation rates is an important point to bear in mind. Inflation around the world is being dragged lower on the back of historically low oil prices. This is being compounded by unusually weak global demand and plunging commodities prices. The ever-present threat of equities sell-offs remains and it has the potential to derail many plans for future economic growth.

Brett Chatz

Published: 25 September 2015

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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