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Summary
- Recent developments including Japan’s Q3 GDP data, the October inflation report, and Rengo’s wage demand support the BoJ’s FY 2024 outlook.
- The LDP announced measures to support the economy, including further cash transfers to low-income workers and raising the income tax threshold. Taken with the recent data, it poses the question: why wait for January?
- The market prices a 60% chance of a December rate hike, with the next hike coming by October 2025.
Market Implications
- We think the BoJ will hike in either December or January.
- We expect a flatter yield curve and target 40bps on paying the 1y1y forward JPY swap vs the 5y5y. However, we wait for a better entry point.
Data Suggests December Hike – Why Wait Until January?
The BoJ faces an interesting few weeks as members deliberate the timing of the next rate hike. Governor Ueda is gaining greater confidence in the BoJ outlook, supporting the case for a December hike.
During the October meeting, Ueda notably distanced himself from his ‘time to spare’ narrative. He has since highlighted greater confidence in the capex outlook. To Ueda, this suggests plans are less susceptible to short-term demand fluctuations, meaning private investment should remain strong. He also highlighted that real rates remain low across the curve, which could spur inflation. Finally, there was also an acknowledgement of Rengo’s wage growth target for next year of at least 5%.
Beyond this, there were three developments including the Q3 GDP rebound, broadening services inflation momentum, and USD/JPY returning to 155 which further strengthened the case for December.
Q3 GDP Growth Rebound
The Japanese economy grew 0.9% QoQ SAAR in Q3, above consensus estimates of 0.7%. Driving this rebound was the surprising strength in household consumption, which grew 3.7% QoQ following a 2.7% QoQ increase in Q2.
Strong demand from inbound tourists likely played a key part. Excluding the impact of tourism, domestic consumption increased 2% QoQ, driven by continued growth in durable goods. Meanwhile, services spend was weaker, up just 0.6%.
Overall, this report will be viewed positively as it suggests that household consumption remains on a modestly upward trend. The recent income and inhabitant tax cut may have also played a part in supporting consumption.
Services Inflation is Broadening
Friday’s CPI report showed headline slowed to 2.3% YoY, while core CPI (ex. fresh food) and supercore (ex. fresh food and energy) were higher than expected at 2.3% YoY.
The details were messy. Food prices (mainly rice) increased sharply for the second month. Meanwhile, the recent earthquake scare led to higher insurance premiums, which added 7bps to headline inflation.
Our measure of wage-intensive services, the BoJ’s focus, remained steady at 2.3% YoY. Food away from home increased to 2.8% from 2.7% last month, largely mirroring the increase in Tokyo CPI. Housing repair services also rose sharply to 4.7% YoY from 3.2%, while apparel services rose to 3.2% from 3.0% last month.
There are two main takeaways:
- The increase in food prices may be seen as an example of higher import costs feeding through to domestic prices – i.e. weak JPY effect.
- Preliminary indicators point to services inflation broadening out. More than 92% of services saw price gains above 0%, while 75% saw gains above 1%. Perhaps more promisingly, increased pressure on wage-intensive services is evident in the recent services PPI report. The BoJ should see this as evidence of higher labour costs slowly feeding through to services inflation.
USD/JPY Returns to 155
FX concerns could also support a December hike. In his recent Q&A, Ueda suggested the BoJ would assess the impact that changes in FX may have on their outlook. Meanwhile, high prices are clearly hurting real wage growth, preventing a more robust recovery in consumption.
A weaker JPY may also draw attention from Trump, who has already shown willingness to pre-announce policy direction before his inauguration with the recent tariff threats on Canada and Mexico.
Upcoming Data to Monitor
As the BoJ approaches its December meeting, several upcoming data points could move the needle:
- Tokyo CPI – 28 November.
- Nationwide wage data – 5 December.
- BoJ’s Consumption Activity Index – 6 December.
- Q3 GDP (2nd est.) – 8 December.
- Tankan survey – 12 December.
Q3 GDP revisions and the Q4 Tankan survey are the most important. Assuming no surprise, the BoJ likely has everything required to hike in December. So why wait?
No hike will reveal a lot about the BoJ’s focus. A clearer guide in December, followed by a January hike will tell us that the BoJ is looking to provide clearer communication, while a delay till March could signify greater importance on the spring wage negotiations.
Fiscal to Further Boost Consumer
Strengthening the outlook for next year is the $142bn Cabinet-approved fiscal package. While the overall package (including central government spend) is about the same size as last year, the outlined policies appear more targeted. Three of the four are designed to support consumers:
- An increase of the limit for income tax exemptions from the current ¥1.03mn ($6,615). Although the new limit will be agreed as part of FY2025 tax reforms, it is unlikely to be as high as the ¥1.78mn threshold proposed by the DPFP.
- A further cash handout of ¥30,000 ($192) to households not subject to resident tax. There will also be a further handout of ¥20,000 per child. This is comparable to the ¥40,000 income and inhabitant tax cut from earlier this year.
- Extending the existing subsidies for gasoline and utility bills to March.
- Investment in semiconductor and artificial intelligence sectors totalling ¥10tn ($65bn) by 2030.
The most impactful of these policies is the increase in the income tax exemption. It promises a dual economic benefit: increased disposable income and expanded labour market participation, especially among women who currently limit their earnings to avoid tax thresholds.
The second and third measures provide one-off benefits that recipients could save (rather than spend) and are unlikely to change the economic outlook.
Overall, these measures support next year’s growth outlook but are unlikely to add more than 0.3% to GDP growth.
Rates Picture in 2025 – Bias for Flatter Curve
By mid-2025, the Japanese economy could see less accommodative real rates, solid real wage growth, and stronger domestic demand – a sharp contrast to now. In this scenario, the BoJ would still guide towards further hikes while maintaining the current gradual pace as they approach the bottom of their neutral range. The BoJ must go slowly to ensure inflation remains durably higher.
The rates market has recognised the increased odds of a near-term hike, pricing a 60% chance of a December hike and two full hikes by October 2025. The 1y1y JPY forward swap has risen 15bps since the start of the month, making paying rates outright less attractive.
Another option to explore is the market pricing a higher terminal rate over time as it gains greater confidence on Japan’s outlook. Said differently, the market has enough confidence in the near-term inflation outlook but less confidence in the medium-term growth outlook.
Currently, the market is pricing a terminal rate of around 85bps per the 2y3y forward swap/ 2y3m forward swap. Further tightening on a firmer growth outlook should lead to a flatter yield curve as the short end underperforms the long end. This should lift the 1y1y swap to 1%, (possibly to 1.2%) i.e. the lower end of the BoJ’s neutral estimate. The flattener also works in an environment where the Japanese domestic economy is doing well, while global duration is bid perhaps due to weakness in Europe or faster disinflation in the US (i.e. bull flattening).
Therefore, paying the 1y1y vs 5y5y forward swap with a target of 40bps from the current rate of 58bps seems reasonable. This would be consistent with the relationship between the 1y1y swap rate and 1y1y vs 5y5y curve year-to-date.
For now, we hold off entering the flattener and instead look for a better entry point on weaker data, or market volatility similar to July/August this year.
The main risks to this view are a weaker global growth backdrop from tariffs, the BoJ revising its view of neutral lower, further Chinese economic weakness, and market volatility stemming from the US.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)