Sovereign credit, inflation, and bond yields

Lars Christensen sent me this link this morning...face, meet palm. The article is painfully wrong about the effect of inflation on bond yields and other related risk premia. The interviewee is obviously not reading any market monetarists, and apparently not looking much at market indicators either. Navel gazing at its worst.

“The volatility in the JGB market was a surprise to policy makers,” Masanao said. Abenomics caused a “big secular shift on how investors look at JGBs,” he said, adding that they should demand a higher risk-premium with the rising volatility and the potential “tail risk” of higher inflation.

 No! For a country with a highly depressed level of nominal output (NGDP), increased inflation expectations is a net positive. Higher inflation will reduce Debt/NGDP, increase the velocity of money, and increase overall output in both nominal and real terms. These are all good things, and the market knows it even if 'big men' are clueless.

In the above chart:

1. Green = nominal yield on 5 year JGBs
2. Yellow = price of 5YR CDS on JGBs (Credit risk)
3. White = 5 year break even inflation rate for Japan. 

Focus on the correlation between these variables, not their levels since they're using separate Y-axes. What happens to the price on credit risk (yellow) when inflation expectations increase (March & early May)? It drops. What happens when inflation expectations decrease (late March & late May)? It rises. CREDIT RISK PREMIA ARE NEGATIVELY CORRELATED WITH INFLATION.

So - what is happening in the real economy? Imports, Exports, & RGDP are UP! In fact imports increased even more than exports, despite a much weaker Yen. These better figures do not represent Japan's increasing competitiveness in foreign markets, they represent an increase in domestic demand.