Inflation, yields and portfolios in Japan: Adapting to changes

The main drivers of these rising yields have been the positive outlook for the Japanese economy and elevated inflation. The BoJ’s recent forecast shows that while the country’s economy is likely to keep improving, inflation may remain elevated for some time.² Core inflation remained hotter-than-expected in February at 3% y/y. Currently, the market priced in two more 25bps hikes, expecting the policy rate to rise to near 1% by the end of 2025 (Chart 2). ³

What’s the macro case for two or more hikes?

Are these market expectations justified? We believe further hikes are almost certain this year but the pace will depend on changes in macro conditions, mainly inflation. And if the local intensifying wage-inflation spiral and the rising output gap continue their trends, sustained inflationary pressure may lead to faster-than-expected rises. 

The wage-price spiral

It is the time of year when the Spring Shunto – Japan’s annual wage negotiation between major corporations and unions – begins. Following two years of sizable wage hikes – to levels unseen in decades – unions, such as Rengo, are demanding yet another brisk pay rise.⁴ 

As the BoJ noted in its February meeting, “…and medium- to long-term inflation expectations will rise with a virtuous cycle between wages and prices continuing to intensify”. Data shows that the large pay hikes that have been in place – mainly since 2022 – have led to higher inflationary pressure (Chart 3).

The output gap

Another key factor behind elevated inflation has been the improving output gap: the difference between actual growth and potential average growth. The BoJ estimates an average potential growth rate of around 0.5% y/y in recent quarters,⁵ a figure dwarfed by much faster rates of growth since Q3 2024, which have led to a continued improvement in the output gap (Chart 4). 

The output gap is also a factor of the utilisation of labour and capital. Tightening labour market conditions, which are possible in the longer term,⁶ and which have led to rising labour productivity compared to the past average, mean that the output gap is likely to continue to improve. This too supports wage growth.  

What’s next? 

If inflationary pressure continues, it could create an environment in which the BoJ has to make ongoing and fairly dramatic adjustments to its monetary policy – a scenario likely to introduce further volatility and the possibility of negative returns in JGBs.

As Chart 5 shows, the correlation between Japanese equities and JGBs generally increases with local inflationary pressure, reducing the effectiveness of bonds as an equity diversifier.

The lesson here is that there is no guarantee that the bond/equity correlation will turn negative, considering the inflation outlook. In such a rapidly evolving market, maintaining a diversified portfolio can feel like chasing a moving target. Not only do bonds provide less of a diversification benefit now than they have done in the past, but they also demand a higher proportion of investors’ risk budgets.

Chart 6 shows that as bonds’ correlation with equities ratchets higher, bonds’ risk contribution also rises – illustrated by a 60/40 Japanese portfolio.

As a result, we believe investors should consider alternatives and complementary assets to high quality fixed income assets, such as gold.

What makes gold a strategic asset for Japanese investors?  

Our analysis shows gold to be an effective complement to equities and broad-based portfolios. A store of wealth and a hedge against systemic risk, gold has historically improved portfolios’ risk-adjusted returns and provided liquidity to meet short-term cashflow requirements in times of market stress. 

A contributor to growth

Investors have long considered gold a beneficial asset during periods of uncertainty. Yet, historically, gold has generated long-term positive returns in both good and bad economic times, outperforming many other major asset classes over various horizons (Chart 7). And following a stunning 40% return in 2024, gold, in yen, continues to outperform other local assets in 2025 to date.

Gold’s diverse sources of demand not only give it a particular resilience, but also the potential to deliver solid returns in various market conditions. Gold is, on the one hand, often used as an investment to protect and enhance wealth over the long term (counter-cyclical demand), but on the other hand it is also a consumer good, via jewellery and technology demand (pro-cyclical demand).

Diversification benefits

Effective diversifiers are sometimes hard to find. In fact, many assets become increasingly correlated as market uncertainty rises. Gold is different in that its correlation to local equities decreases as stocks go down. Meanwhile, investors won’t miss the party when equities rally, as gold’s correlation with equities rises at such times (Chart 8). 

Improve portfolio performances

Our analysis of investment performance over the past 5, 15 and 20 years emphasises gold’s positive impact on a hypothetical portfolio – structured based on allocations of a typical Japanese Corporate Pension Fund. 

It shows that an average portfolio would have achieved higher returns and lower risks if 2.5%, 5%, 7.5% or 10% were allocated to gold (Chart 9). 

Conclusion

Japanese bond yields have risen rapidly while local inflation has been running elevated…at levels well above previous years. The BoJ has hiked rates three times since last March – bringing the policy rate to 0.5% – with more hikes expected; these are especially likely if inflationary pressure intensifies in the scenarios we have noted here. 

With yields rising and inflation remaining sticky, we find that the correlation between JGBs and local equities may also increase, based on historical patterns. In fact, the status of JGBs as a portfolio diversifier has already been dented.

Our analysis shows that gold has the potential to help institutions navigate through this wave of rising correlation between bonds and equities. Gold has provided attractive returns and been an effective diversifier for many decades, and should continue to help institutions achieve their portfolio goals. Our simulation demonstrates that even a small allocation to gold could improve returns and reduce volatilities in a hypothetical Japanese pension portfolio. In an environment where economic and geopolitical uncertainties prevail, we believe gold could shine bright as a strategic asset. 

Footnotes:

¹For more, see: Monetary Policy Meetings : 日本銀行 Bank of Japan, February 2025.

²For more, see: Monetary Policy Meetings : 日本銀行 Bank of Japan. March 2025.

³Based on Bloomberg consensus of Japanese policy rate by December 2025 as of 25 March.

⁴For more, see: Big Spring Wage Hikes at Japanese Companies Again in 2025 | Nippon.com, 24 March 2025.

⁵For more, see: Monetary Policy Meetings : 日本銀行 Bank of Japan, January 2025.

⁶For more, see: (BOJ Review) Effects of Demographic Change on Labor Market and Wage Developments : 日本銀行 Bank of Japan, 6 March 2025.