BOJ Rate Hikes Hold the Key to Arresting Yen's 5% Slide

The yen has depreciated nearly 5 percent since the Iran war began in late February, as the U.S.-Japan two-year yield gap widened to 2.8 percentage points from 2.15.

"A surprise hike by the Bank of Japan would go a long way to reset expectations around the central bank's determination to tighten monetary policy," said Fred Neumann, chief Asia economist at HSBC.

The U.S. two-year Treasury yield has risen from 3.39 percent at the end of February to around 4.25 percent recently, while the two-year Japanese government bond yield hit 1.54 percent on Monday, its highest since May 1995. The BOJ kept its policy rate unchanged at 1 percent at its last meeting but warned for the first time that underlying inflation could exceed its 2 percent target.

With the Fed expected to move in mid-September, the BOJ faces a critical test at its own meeting days later. If it fails to hike, the yen's slide could resume, pushing imported energy costs higher and threatening Japan's fragile recovery.

Intervention Buys Time, Not a Trend

The rare joint U.S.-Japan intervention last week — the first in 15 years — triggered the largest squeeze in yen short positions in nearly two years. The yen rose 1 percent in early Asian trade Monday to a high of 155.20 per dollar, its strongest in about three months, moving away from the 40-year low of 163.99 hit in July. Japan spent $70 billion in late April and early May to prop up the yen, but the rebound was brief, as was the case in 2022 and 2024 when the country intervened alone.

Speculators had amassed net short positions on the yen worth about $12.5 billion before the intervention. Nomura estimates Japan may have ammunition to spend as much as 30 trillion yen, targeting levels of at least 154 yen to trigger momentum traders. "If this works, could accelerate the move to 150," they said in a note.

But analysts remain skeptical of the durability of an intervention-led surge without policy follow-through. "History is quite clear, coordinated intervention packs a punch, and it tends to be successful," said Elias Haddad, global head of markets strategy at BBH in London. "It does take time for the trend to ultimately move in the right direction of the intervention."

The BOJ's September Test

The BOJ's cautious approach to raising rates has been a key driver of yen weakness. Japan's headline consumer-price index rose 1.7 percent in June from a year earlier, but the central bank itself expects that number to climb because of higher oil prices, with inflation likely to accelerate above its 2 percent target in the second half of the year.

The weak yen exacerbates this impact by increasing the cost of imported energy. That should provide justification for the BOJ to start hiking rates in September, after an earlier hike in June. Japanese bank stocks have also felt the pressure, with shares falling 3.11 percent as rate expectations shift.

Some argue the BOJ is hesitating because higher rates on Japanese government debt would further undermine the country's finances. At roughly 200 percent of GDP, Japan's debt is famously high. But Japan's underlying fiscal position is stronger than many appreciate — including the government's huge stock of financial assets, net debt-to-GDP is about half that, and analysts at Capital Economics see it falling to 80 percent by 2028.

Prime Minister Sanae Takaichi, who has announced a plan to sharply cut consumption taxes on food items, is unlikely to support austerity to shore up the yen. That leaves the BOJ as the primary lever. If the Fed moves in mid-September as most market participants expect, the BOJ would have little choice but to follow suit when its own meeting takes place a few days later.

HSBC currency strategists Joey Chew and Paul Mackel said they lack confidence in projecting a downtrend for dollar/yen "unless we see much faster BOJ rate hikes, and the government taking a clearer stand on the JPY as well as dialling back its ambition for fiscal expansion."

For yen bears, coordinated intervention has not fundamentally altered the outlook but only delayed another test of the lows. Chandresh Jain, EM Asia rates and FX strategist at BNP Paribas, said the yen's bounce provided an opening to initiate a long dollar/yen position through options, betting the yen will weaken in the near term. "We have seen multiple times intervention around 160, and then now at 164-ish — so seems like these numbers are getting uncomfortable for them, rather than just the pace which used to be the case historically."

This article is for informational purposes only and does not constitute investment advice.