Bank of Japan Rate Hike Could Come Sooner Than Expected If Yen Weakness Persists

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September 22, 2023

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The Bank of Japan may be forced to raise interest rates sooner than anticipated if the Japanese yen continues to weaken significantly against the U.S. dollar, according to JP Morgan Asset Management’s global head of fixed income, Bob Michele. The yen has fallen over 11% against the dollar this year, recently touching 148 yen per dollar, nearing the critical 150 level. Michele told CNBC that if the yen crosses that threshold, the BOJ will likely re-evaluate its ultra-accommodative monetary policy stance.

“I think where their hand could be forced is looking at dollar-yen. We’re awfully close to 150…when that starts to get to 150 and higher, then they have to step back and think: the selloff in the yen is now starting to import probably more inflation than we want,” Michele stated.

While a weaker currency benefits Japanese exports, it also makes imports more expensive at a time when major economies are grappling with high inflation. This dynamic could provide justification for the BOJ to hike rates sooner than financial markets expect, perhaps as early as the first half of 2024 according to some economists.

The BOJ has kept its key short-term interest rate at -0.1% while targeting 10-year Japanese Government Bond (JGB) yields around 0% under its yield curve control policy. This stance diverges significantly from other major central banks like the U.S. Federal Reserve, which has raised rates aggressively to combat inflation.

Yen Carry Trade Could Unwind

The BOJ’s prolonged easy money policies have encouraged investors to borrow cheaply in yen and invest in higher-yielding foreign assets, known as the yen carry trade. However, Michele warns that normalization of JGB yields could spark a decade-long repatriation of capital back to Japan as rate differentials narrow.

“Japan has been the mother of the carry trade for decades now and so much capital has been funded at a very low cost in Japan and exported to foreign markets,” Michele explained. “I worry as the yield curve normalizes and rates go up, you could see a decade — or longer — of repatriation. This is the one risk I worry about.”

JGB yields recently hit 0.75%, the highest level in over a decade. This has already prompted some unwinding of yen carry trades across various asset classes. A BOJ rate hike risks accelerating this dynamic, potentially causing volatility in Japanese and global financial markets.

BOJ Remains Cautious Despite Inflation

In July, the BOJ loosened its yield curve control policy by widening the band around its 0% JGB yield target. This was the first policy adjustment under new Governor Kazuo Ueda. However, BOJ officials have remained cautious about fully exiting stimulus despite core consumer inflation exceeding the 2% target for 17 straight months.

The BOJ believes current inflation lacks sustainability without meaningful wage growth that would stimulate household spending and broader economic growth. But Michele contends that persistent yen depreciation could override these concerns by further stoking imported inflation.

Timing of Rate Hikes Uncertain

Economists adjusted rate hike expectations after Governor Ueda stated in September that the BOJ could have sufficient data by year-end to decide on ending negative interest rates. This prompted many forecasters to predict potential tightening in the first half of 2024.

However, the precise timing remains uncertain and dependent on yen and inflation trends. The risks for Japan’s economy and markets will escalate the longer the BOJ maintains stimulus after other central banks tighten policy.

Unwinding decades of extraordinary monetary easing won’t be easy whenever the BOJ pulls the trigger. But letting the yen slide unchecked and inflation spiral could force the central bank’s hand sooner rather than later.