As investor try to piece together a projection for future Japanese inflation, many have discounted the country’s government bond market as a reasonable estimate for the nation, in light of the Fed’s decision to raise interest rates by 25 basis points. As a result, many fund managers have decided to look to the interest-rate swaps market, as a gauge to the direction of the market with regard to the future of interest rates.
Interest-rate swaps are derivative contracts that banks, investors, and traders use to protect themselves against fluctuations in interest rates. In doing so, two parties agree to exchange a stream of payments over a period of time, in which one side agrees to make fixed-rate payments, while the other side agrees to make the floating-rate (variable) payments. Therefore, if you believe interest rates are going to rise, you’ll agree to enter into a fixed rate payment to protect yourself against future losses. This, in turn, provides ample information to investors who meticulously examine the spread between the swap rate and the underlying bond of the same maturity to signal the future direction of interest rates
As such, the swaps market has hinted to a possible derailment of Japanese inflation, which has showed promising signs in January. While these derivative contracts (swaps) may seem rather obscure and deeply complicated, they offer investors a means of analyzing the fixed income space through a filtered lens without the noise of insignificant market moves. Theoretically, signs of inflation should stem from bond yields that are directly priced in accordance with interest rates, and therefore subject to swings by central bank policy. However, with the Bank of Japan’s quantitative easing tactics, buying back bonds in bulk (80 trillion yen), interest rates have been artificially low. Thus, the information received form the bond market is insufficient, and skewed in accordance with Japanese banking practices.
Swaps, on the other hand, are not subject to the same minor swings of market sentiment as they derive their value from intrinsic and extrinsic values such as the duration of the contract, the value of the underlying asset and the volatility attributed to said asset. As a result, the indications received via analyzing price discrepancies present between the contracts allows investors and traders alike to make speculative bets in the direction of the overall market. According to Naka Matsuzawa, Japan rates strategist at Nomura Securities Co. in Tokyo,”The swap rate is more indicative of what the market is thinking about inflation and policy-rate expectations—if you look at cash bond yields alone, you get misled.”
Furthermore, in comparing the bond and swap rate, price discrepancies begin to arise whereby the bond overly reacts to news and sentiment to force mispricings within the market. This variance in pricing is most evident with the five-year interest-rate swap rate which last traded at 24 basis points above the yield on the five-year Japanese government bond. Though this aggressive uptick would normally signal that the market expects higher rates on the back of inflation, a closer inspection would reveal that while the swap was priced above the five-year Japanese government bond, the swap rate itself had only bobbed around 1 basis point point, a clear sign that investors were no longer betting aggressively that rates would be higher in the future. As Colin Harte, rates strategist at BNP Paribas Investment Partners, stated “If you have a cash market distorted because of central banks, the swaps market is the canary in the mine.”
In Japan, five-year swap rates took a big leg up after the U.S. election amid rising rates globally and pumped-up expectations for inflation, rising as high as 13 basis points in early February from minus 4 basis points over that period. Yet there’s still plenty of doubt that inflation may linger as unrest in the US and tensions within the UK threaten to complicate the fiscal landscape. According to Makoto Yamashita, Japan rates strategist at Deutsche Securities Inc, said that “hitting a 2% target by the BOJ’s proposed deadline of the fiscal year 2018 is impossible, particularly if oil prices continue to slide and the yen strengthens.”
Looking ahead, investors should be cautious as to the potential volatile swings within the bond market as US interest rates are poised to rise twice more this year and geopolitical events threaten to shake up the markets with news of Trump’s proposed legislation and GOP initiatives.