[Part 2] Determinants of Policy Interest Rates and What 'Widening Long-Short Spread' Means

Hello! This is FP Mitchy.

In the previous article, I talked about the background of how Japan has finally entered a ‘world with interest rates.’ In this article, although some technical terms will appear, I will explain the ‘widening long-short spread,’ which is the most important keyword in the current financial market, in as simple terms as possible.

Even for someone like me who has been in the financial industry for a long time, there are many situations where I feel that recent intense interest rate movements ‘do not follow the textbook.’ Let’s grasp the basics together!

What does the policy interest rate look at to be determined?

When the Bank of Japan decides the policy interest rate (short-term interest rate), it is never decided by intuition or atmosphere. It is carefully observing the following two important economic indicators.

1. Consumer Price Index (CPI)

This is an indicator that shows ‘how much the prices of goods and services are rising.’ Currently, price pass-through (price increases) is progressing in a wide range of fields, such as eating out and services, not just the temporary surge in energy prices, and it is in a state where it is stably clearing the ‘2%’ target set by the Bank of Japan [Source: Ministry of Internal Affairs and Communications ‘Consumer Price Index’].

2. Wage Growth Rate

If only prices rise and salaries remain the same, life will only become more difficult, right? The Bank of Japan is carefully judging the timing of interest rate hikes while checking the high wage increase rate in the spring wage negotiations and the trends in ‘real wages’ in the Monthly Labour Survey.

It is precisely because these ‘price’ and ‘wage’ data are showing strong numbers that the Bank of Japan was able to confidently raise the policy interest rate to 1.25%.

What is the ‘widening long-short spread’ happening in the market now?

Now, this is the main topic for today. Have you ever heard the term ‘yield curve steepening’ in the news? It sounds difficult, but in short, it means ‘a state where long-term interest rates are rising more significantly than short-term interest rates.’ This is called the ‘widening of the long-short spread (interest rate differential).’

There are two main types of interest rates.

• Short-term interest rate: Influenced by the policy interest rate controlled by the Bank of Japan. (Example: Short-term deposit interest rates and the base for variable mortgage interest rates)

• Long-term interest rate: Mainly refers to the ‘yield on 10-year government bonds.’ It is also subject to control by the Bank of Japan, but it is determined more by ‘investors’ future predictions’ in the market. (Example: Base for fixed mortgage interest rates)

What is happening now is that while the Bank of Japan raised the short-term interest rate to ‘1.25%,’ investors are selling bonds because they predict that ‘if inflation is this entrenched, Japanese interest rates should rise even more,’ so long-term interest rates are rising sharply beyond the hike in short-term interest rates.

Why do long-term interest rates rise more significantly?

For example, if you were to lend money for 10 years, you wouldn’t think it’s worth it unless you receive high interest if you think, ‘Prices might continue to rise for the next 10 years (= the value of money will effectively decrease).’ Market investors are thinking the same thing, which is why long-term interest rates are being pushed up steadily.

Summary: What will be the impact on household finances?

How does a ‘widening long-short spread (a sharp rise in long-term interest rates)’ affect our household finances?

In conclusion, for things like mortgages, the burden of ‘fixed-rate’ loans will become heavier sooner and more significantly than ‘variable-rate’ loans. Conversely, for savings, interest rates on longer-term time deposits will become more attractive.

The financial markets are already moving in anticipation of the ‘Bank of Japan’s next move.’ We, too, need to plan our finances wisely so as not to be outpaced by the market’s foresight!

In the next installment, [Part 3], I will explain another factor behind this sharp rise in long-term interest rates: the ‘Bank of Japan’s reduction in government bond purchases (QT),’ from the perspective of a financial planner. Stay tuned!