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Continued Middle East tensions seen keeping long- andsuper-long-term JGB yields elevated
Long-term and super-long-term JGB yield scenario for March 23-27
We project that long- and super-long-term JGB yields will remain at elevated levels for the week of March 23 and may rise further depending on developments in the Middle East. Given the uncertain outlook for geopolitical risks and the approaching end of the fiscal year, we expect only limited new buying. We also anticipate heightened volatility around the 40-year JGB auction on March 24.
During the week of March 16, the news that several tankers appeared to have passed through the Strait of Hormuz eased concerns over geopolitical risks, and on March 18 risk-off trades were unwound, sending stocks, bonds, and the yen higher. That said, the conflict involving the US and Israel against Iran is actually expanding, resulting in greater damage to neighboring countries. Reuters reported on the morning of March 19 that the Trump administration is considering deploying several thousand US troops to bolster its forces in the Middle East, raising concerns about a continued war of attrition.
The longer the fighting persists, the greater the likelihood of widespread damage to energy-related facilities in the Middle East, including Iran, which would reinforce expectations of rising and elevated energy prices. While adverse effects on the real economy are a concern, we should not necessarily assume the existence of a “central bank put” -- i.e., rate cuts (or a postponement of rate hikes) to support the economy -- in an environment characterized by upside risks to inflation. Federal Reserve Chair Jerome Powell clearly stated at his press conference following the FOMC meeting held on 17-18 March that “if we don’t see that progress [on inflation], then you won’t see the rate cut.”
The US and Israeli attacks on Iran, which began on February 28, may mark the end of the long-standing era of accommodative central banks that promptly lowered rates whenever downside risks to economic activity emerged. Needless to say, a central bank’s primary mission is price stability. When demand declines, the expectation is that a deterioration in the output gap will lower inflation expectations. Accordingly, nominal rates are preemptively lowered to stabilize both the output gap and inflation expectations.
The challenge arises in cases where an oil shock or some other form of supply shock simultaneously triggers rising prices and economic weakness. Rising crude oil prices depress economic activity while potentially raising inflation expectations. Higher inflation expectations lower real interest rates. Lower real rates exert a positive effect on demand, which in turn risks intensifying supply constraints and prompting secondary price increases. If the supply shock is temporary, the central bank can proceed with rate cuts (or forgo rate hikes), but if the shock persists or secondary inflation risks intensify, the central bank is likely to adopt a wait-and-see stance or consider raising rates. To achieve longer-term economic stability, it maybe necessary to suppress inflation by raising interest rates, even at the cost of short-term economic sentiment. In Japan, there is a strong sense that the BoJ is ultra-dovish, which it was during the deflationary era, but the world in which central banks operate appears to be undergoing major change.