Japan FI Morning Memo:UK votes to leave the EU,Growing expectations of further BoJ easing

　　The UK's vote to leave the EU in the recent referendum is likely to trigger risk off due to increased uncertainty about the outlook for the financial markets. We expect yields to decline as central banks move to ease through providing liquidity and other measures in an attempt to dispel such uncertainty. Our economists have lowered their outlook for UK economic growth to 1.5% (- 0.2ppt) for 2016 and 0.9% (-1.2ppt) for 2017. They also cut their outlook for growth in the eurozone to 1.6% (-0.1ppt) for 2016 and 1.1% (-0.4ppt) for 2017. Our forecasts for exchange rates at the time of the Brexit were GBP1.15/USD and EUR1.05/USD for end-2016. In addition, we expect the 10y Bund yield to trade around -0.10-0.15% for now and the 10y UST yield to range between 1.00-1.50% in 2016, centering around 1.25%. As for changes in monetary policy at major central banks, we expect the BoE to cut its rate by 25bp in Jul- Sep, with further easing likely. The ECB will act depending on financial markets, but we think it is more likely to expand QE and strengthen liquidity supply through lengthening durations rather than cut rates.

　　The impact on JGB yields is likely to mainly come via forex and the BoJ. Yields overall are likely to face downside pressure until the BoJ actually moves given growing expectations of additional easing. We recommend going long JGBs on a trading basis until the BoJ implements further easing and the financial markets return to calm.

　　JGB yields last week fell sharply on the 24th, partly due to the UK's vote to leave the EU. The superlong sector was sold temporarily as the BoJ did not purchase JGBs in the superlong sector between the two auctions for enhanced liquidity and the 20y JGB auction. However, the curve bull flattened following a smooth result to the 20y auction. JGB yields tested further downside as the UK's vote to leave the EU triggered risk off, with the yen briefly strengthening to beyond JPY100/USD. The 10y yield declined to -0.215% and the 30y fell to 0.125%. We expect JGB yields this week to move depending on the direction of overseas financial markets and central banks. The negative impact of the UK leaving the EU is likely to mainly come via yen appreciation. Concerted intervention may have been a response if this was a traditional currency market move, but is unlikely given that no financial shock has occurred. We think expectations of additional easing by the BoJ will heighten, partly because of the upcoming Upper House election. We note that US core capital goods orders, announced on the 24th, declined further, painting a negative picture of the US economic outlook.

　　The focus this week will be on the EU Summit on the 28-29th. Investors will be looking for a clear message to stabilize the financial markets. Important data on the fundamentals side includes leading US economic indicators such as the US Consumer Confidence Index for June (28th), the ISM Manufacturing Index for June, and auto sales (1st). Concerns of a deterioration in fundamentals should abate somewhat if these leading indicators improve, but the focus on corporate and consumer sentiment following the Brexit is likely to muddy the waters. In addition, we expect the 10y UST yield to move in a range around 1.25% because leading economic indicators have been generally mixed. In Japan, May core CPI and the BoJ's June Tankan (1st) will be a focus. We expect the CPI to show a slowdown in inflation excluding energy. Expectations of additional easing by the BoJ would probably be strengthened if the Tankan reveals a deterioration in the Business Conditions DI and downward revision of earnings forecasts. The BoJ on the 30th will announce its JGB purchase plan. We see the risk of a slight reduction in purchase operations in the superlong sector given flattening has progressed. It is possible that only purchases in the 25-40y sector will be reduced given the 20y30y spread is narrowing.