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JGB market starts to focus on stagflation risks
Long-term and super-long-term JGB yield scenario for March 16-19
We expect long- and super-long-term JGB yields will continue responding todevelopments in the Middle East situation for the week of March 16. The Bank ofJapan will hold a Monetary Policy Meeting on March 18-19, and the consensus isthat there will be no change in policy. Since the official statement will be releasedimmediately before a three-day holiday weekend, market action through mid-weekwould be influenced primarily by external factors such as USD/JPY and the 10-yearUST yield, as well as the outcome of the 20-year JGB auction on March 17. If thereis no movement toward a ceasefire between the US, Israel, and Iran and theMiddle East conflict expands further, financial markets are likely to become moreattuned to the risk of global stagflation, thus putting upward pressure on long- andsuper-long-term JGB yields (bear steepening).
In last week’s report, we presented three potential scenarios for the Middle Eastoutlook following the attack on Iran by the US and Israel (February 28): (1)concrete progress toward a ceasefire; (2) no progress toward a ceasefire and anescalation of the conflict that draws in neighboring countries; and (3) prolongedclosure of the Strait of Hormuz, successive attacks on energy-related facilities inneighboring countries, and concerns about severe physical shortages of crude oiland LNG. Events in the week of March 9 followed the second scenario. On March12, Iran’s new Supreme Leader Mojtaba Khamenei declared that the closure of theStrait of Hormuz should be continued, prompting concerns that we may be enteringthe third (risk) scenario.
If developments move in the direction of the first scenario, we would expect to seea reversal of the surge in crude oil prices, a rebound in stock prices, and thecovering of short positions in the yen as financial and capital markets stabilize.However, the reduced uncertainty would increase the probability of a BoJ rate hikein April, leading the JGB curve to bear flatten or bear/bull flatten. In the secondscenario, we would probably see a continuation of rising crude oil prices, fallingstock prices, and a decline in the yen. If financial and capital markets experiencefurther turmoil, the probability of an April rate hike would decline in principle, butsince elevated crude oil prices and a weak yen carry upside risks to inflation in thefuture, market expectations regarding the timing of rate hikes would not retreatsignificantly. If the market begins to worry seriously about the third scenario, risk-averse behavior would intensify, and a credit contraction would become more likely.
We are not experts in geopolitical risk, but we feel the risk of a prolonged war ofattrition between the US and Iran can no longer be ruled out given that a strategyof full-scale resistance would appear to make sense from an Iranian perspective.The following is an excerpt from a Japanese-language report we published onMarch 12:
The attacks on Iran by the US and Israel do not appear to have an exit strategy.How, then, will the war that has already begun eventually come to an end?Historian Yasuaki Chijiwa is chief of the International Conflict Division, Center forMilitary History, at the National Institute for Defense Studies and is a specialist inthe study of how wars end. He addressed this issue in an interview with the AsahiShimbun in August 2022 in the context of Russia’s invasion of Ukraine. Accordingto Mr. Chijiwa, the decision to end a war is typically led by the side that has thesuperior military position. From the perspective of that side, there are two ways toend a war: 1) a fundamental resolution of the causes of the conflict by defeatingthe enemy thoroughly enough to ensure there will never be another war (as in thecase of World War II and Nazi Germany); and 2) a peace by compromise in whichthe winning side refrains from going that far and makes concessions because itwishes to avoid further sacrifices of its own soldiers’ lives (as in the Gulf War, theKorean War, and the Vietnam War). Since these two approaches are fundamentallyopposed, the way the war ends is determined by which approach is emphasized bythe side with the military advantage. The US has a more powerful military than Iran,and we think President Donald Trump, who faces midterm elections later this year,will have little choice but to choose the second option over the first. Although theside at a military disadvantage cannot achieve a fundamental resolution of theconflict on its own, it can increase the current sacrifices required of the winningside by demonstrating resistance and thereby extract more favorable peace(ceasefire) terms, according to Mr. Chijiwa. Iran is likely attempting to bring aboutmore favorable terms for itself by forcing the US and Israel to make greater currentsacrifices, including economic ones. In short, we cannot rule out the risk of aprolonged war of attrition between the US and Iran.