Graph 2 shows the results of a factor contribution analysis (FCA) of the 10-year JGB yield based on the Fisher equation, which states that the long-term bond yield equals the equilibrium real interest rate plus the expected inflation rate. Here, the equilibrium real interest rate refers to the real interest rate that balances aggregate demand with aggregate supply and savings with investment under a state of full employment. Over the long run this approximates the potential growth rate, so we have used the potential growth rate as a proxy. We used the break-even inflation (BEI) rate on 10-year index-linked JGBs for inflation expectations. The risk premium represents the difference between the actual and theoretical long-term bond yield (actual minus theoretical). The actual 10-year JGB yield climbed 62.5bp between (1) and (2) in Graph 1. Our analysis broke this down into contributions of +30.0bp for the potential growth rate, +97.5bp for inflation expectations, and -65.0bp for the risk premium. The 10-year JGB yield would probably have risen further if the negative contribution of the risk premium had been smaller.
We therefore expect the actual 10-year JGB yield will eventually put in a top and turn lower. In addition to a sustained and powerful stock effect, inflation expectations are likely to cool as core CPI inflation subsides (G. We forecast that core CPI inflation, which came in at 3.3% in Apr-Jun 2023, will slow sharply to 2.8% in Jul-Sep, 2.1% in Oct-Dec, and 1.8% in Jan-Mar 2024, breakin below the 2% price stability target. We think expect inflation expectations -- which are formed via an adaptive (backward-looking) mechanism -- will decline as well,pushing the 10-year JGB yield lower. - MUFG
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