Struggle for inflation reading makes Japan govt bonds a minefield
* Inflation-linked JGBs too illiquid to provide clear signals
* Japanese institutions positioned for deflation - strategist
TOKYO, July 19 (Reuters) - The Japanese government bond market is where the Bank of Japan will win or lose its battle to push Japan's economy out of deflation. The problem for investors is that in the absence of any clear indicators of inflation expectations in Japan, the market could act like a minefield that explodes without warning. The Bank of Japan has launched an aggressive monetary expansion with the stated aim of generating 2 percent consumer inflation in two years. Most investors are positioned to expect Japan's years of low-grade deflation to continue, or for real interest rates - nominal rates adjusted for price changes - to remain low. Investors risk being caught out if inflation outpaces interest rates, and they fail to predict the shift in time to reallocate their assets. "JGBs have been the greatest thing since sliced bread, because they have massively outperformed Japanese equities and real estate in recent decades, so it's not surprising that investors have ended up with portfolios heavily weighted toward government bonds," said Neale Vincent, a fixed-income strategist at Nomura Securities in Tokyo. "Japanese institutions are pretty well-positioned for deflation, and are not well-positioned for inflation. If they have no good indicator of inflation and they just leave all their assets as they are, they're going to be in for a big shock later on," he said. There were about 821 trillion yen ($8.2 trillion) of JGBs outstanding as of the end of March. More than 90 percent were held by domestic investors, with Japanese life insurers holding about a quarter of the total.
'NO PERFECT TOOL' An accurate measure of inflation expectations is critical for investors. Holding fixed-income assets makes sense in deflation because the value of their returns increases as prices of goods fall. Since inflation does the opposite, investors would typically reduce their bond holdings when prices are rising. On the other hand, if inflation expectations are rising faster than nominal bond yields, that means real interest rates are falling, another typical reason to hold bonds. Investors in U.S. bonds watch the performance of inflation-protected Treasuries, which represent about 10 percent of outstanding U.S. government debt, to track price expectations. But no comparable market exists in Japan. Japan issued inflation-linked government bonds until 2008. With only about 2.3 trillion yen left outstanding after finance ministry and central bank buybacks, they represent a tiny fraction of total outstanding government bonds. Critics say their illiquidity means they are of limited use in tracking inflation expectations. The finance ministry says it will resume issuing 10-year inflation-protected bonds in October. Unlike the previous notes, they will have a principal guaranteed component, which analysts say will distort their accuracy as a gauge of price expectations. "There is no perfect tool to measure inflation expectations in Japan as of now," says Tadashi Matsukawa, head of Japan fixed income at PineBridge Investments in Tokyo. He said inflation-linked bonds are the best option, but he looks at a range of data, such as commodities and consumer price trends "to guess what will occur." Japan prices have been trending lower for well over a decade. Two percent inflation based on the headline consumer price index has rarely been seen since early 1992. The CPI, by its nature a backward looking measure of inflation, fell 0.3 percent in May from a year earlier. Even settling on which measure of inflation will determine policy direction is difficult. A government official told Reuters earlier this month that Tokyo planned to use a CPI measure that excludes energy costs when determining whether the economy has escaped from deflation. The change will effectively raise the bar for Abe's inflation goal, as it means that higher energy prices will be taken out of the equation, giving politicians ammunition to push the BOJ into taking further policy action. Methods for looking ahead are even murkier. The BOJ conducts is own surveys of inflation expectations and it also looks at other indicators, including Cabinet Office surveys of consumer sentiment, a survey of private-sector economists and a market survey. Earlier this month, BOJ Governor Haruhiko Kuroda said after a policy meeting that various surveys show inflation expectations are heightening. However, the BOJ cut its median forecast for consumer inflation, excluding food, to 0.6 percent for the business year to March 2014 from 0.7 percent forecast in April.
'NOT TRADING ON THE BACK OF INFLATION' The BOJ also factors in the breakeven inflation rate, or BEI. This is the difference between nominal bond yields and the yields on inflation-linked bonds of similar remaining maturity. The BEI now implies about 118 basis points of inflation over the next five years. Most economists believe that about two-thirds of that is likely due to a scheduled hike of Japan's sales tax to 8 percent in April from 5 percent now, and then again to 10 percent in October 2015. Naomi Muguruma, senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities, said the illiquidity of inflation linked bonds makes the BEI reading unreliable. "We just don't have a good indicator to show what the inflation expectation is in Japan," Muguruma said. So investors can only keep watching JGB yields for signs they would reveal a consensus that inflation is set to rise, analysts said. "Nominal yields would go up. It's as simple as that," said Muguruma. Analysts at Morgan Stanley MUFG Research calculate that Japan's exit from deflation, which they define as a rise of more than 0.5 percent in a year for consumer prices excluding food and energy costs, would lift the 10-year JGB yield by 114 basis points. The 10-year yield has been mostly stuck in a range between 0.80 and 0.90 percent since late May. "The JGB market is definitely not trading on the back of inflation here," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch. ($1=100.62 yen)
(Editing by Neil Fullick)