During early Asian trading on Wednesday, the US dollar against the Japanese yen was in a narrow, elevated range, trading near 163.70. Markets are cautious ahead of the FOMC decision and the Bank of Japan's policy announcement.
The Bank of Japan is set to announce its interest rate decision on Friday, with widespread expectations to hold rates at 1.00% following a 25-basis-point hike last month. While some market participants believe the tightening cycle could accelerate with a potential hike in October, most analysts think that even moderately hawkish signals from the central bank would struggle to significantly boost the yen or alter the broader USD/JPY outlook. The core contradiction in the market currently lies in the tension between the Bank of Japan's slow rate hike path and the persistently weak yen, which is being dominated by Federal Reserve policy expectations and energy price trends.
The consensus for rate hikes is clear, but disagreements over timing remain.
When the BOJ raised its policy rate to 1.00% last month, it maintained a tightening bias and concluded that further unwinding of monetary easing measures is necessary. As always, the timing of such adjustments depends on developments in economic activity, prices, and financial conditions. Since the mid-June meeting, the BOJ has observed strong retail sales data and, more importantly, a robust second-quarter Tankan survey for large enterprises. Business sentiment has recovered to its highest level since 2018, bolstering the central bank's confidence in the "virtuous cycle" of corporate profits leading to wage growth, consumption, and then prices. Although the BOJ acknowledges downside risks to growth from Middle East conflicts and rising energy prices, most expect it to maintain its view that global AI-related capital expenditure continues to support global demand. This suggests that the bank's quarterly outlook report, due Friday, may show little change in its forecasts for moderate GDP growth.
Inflation outlook is stable, but import prices and a weak yen pose upside risks.
Excluding fresh food, energy, and institutional factors, Japan's CPI year-on-year has fallen from a peak of 3.6% last summer to a low of 2.1% in May. Apart from previous government measures to reduce the cost of living, such as consumption tax breaks and lower education costs, the government will provide electricity and gas subsidies from July to September this year to offset the energy shock. The BOJ's forecasts for inflation over the next few years are not expected to change significantly, still pointing to long-term inflation stabilizing around 2.0%. However, the BOJ has noted the risk of inflation spreading among businesses and should have observed inflation expectations from the Tankan survey, where all enterprises expect inflation to be 2.6% year-on-year in five years, firmly above the central bank's 2% target. The BOJ is also aware that import prices surged 30% year-on-year in June, the highest since 2022, and that the yen is at its weakest levels since the 1980s.
Key points for the decision day.
Regarding this decision, any outcome other than maintaining the 1.00% policy rate would be a surprise. The voting pattern may attract attention. Governor Kazuo Ueda is expected to return after a recent illness, restoring the policy board to its full nine members. The focus will be on whether any members vote for a consecutive rate hike. Hajime Takata, who voted for a hike in January, could be a candidate again this week. A bigger surprise would be if other hawkish members, Junko Nakagawa and Naoki Tamura, join him. Governor Ueda's press conference will be closely watched, but unless he hints at a need to accelerate the tightening cycle, the market reaction may be limited. Notably, a Cabinet Office representative attends these meetings, and the BOJ meeting minutes reflect their view that Japan's "shift to a growth-oriented economy is crucial." Investors perceive the BOJ's monetary policy to be under more direct government oversight than other G10 central banks.
Energy prices and the Fed are the dominant variables for USD/JPY.
In the coming months, energy prices and the Fed's reaction function are likely to be more influential in driving USD/JPY than a more hawkish BOJ stance. Wednesday's FOMC meeting will largely determine this direction. Unless the Fed is unexpectedly dovish, or Brent crude suddenly falls back to $70 a barrel, USD/JPY is expected to remain in the 163-164 range ahead of the BOJ meeting on Friday. If Governor Ueda is insufficiently hawkish at his press conference, there is a risk of USD/JPY testing 165, but the risk of FX intervention remains. The BOJ spent approximately $70 billion on intervention from late April to early May and has about $1.09 trillion in remaining foreign exchange reserves. Japanese authorities would undoubtedly prefer to sell USD/JPY when the dollar is weakening to improve effectiveness, but if the 165 area is challenged, they are likely to be forced to act. Regarding the long-term outlook for USD/JPY, the base case scenario, assuming the Fed does not raise rates, targets 158 by year-end. Markets also speculate that the Japanese government is considering supporting the yen by encouraging domestic investors to keep more money at home. Adjusting the investment portfolio allocation of Japan's GPIF pension fund is difficult, but substantial adjustments to products like Japan's new NISA, allowing investors to hold more domestic assets such as Japanese government bonds, would have a significant impact.
Signals from the bond market.
The 5-year Japanese government bond yield is at 2%, a level seen as a medium-term target for the BOJ's policy rate. The 2-year yield is at 1.5%, only 50 basis points above the policy rate, which is relatively mild. The forward market prices the policy rate at 2% in two years. The conclusion is that markets expect upward movement in the BOJ's rate, but at a relatively slow pace. Meanwhile, the 10-year yield is at 2.7%, reflecting substantial expectations for eventual normalization of the central bank's rate. The 5/10-year spread is 70 basis points, making the curve relatively steep. Yields on 30-year and 40-year bonds are both near 4%, notably the same level as the US 30-year yield two years ago. This combination of "mild spreads and a steep curve" reveals a contradiction: low carry spreads indicate low expectations for significant rate hikes in the coming quarters, while a steeper curve points to the "central bank falling behind the curve," failing to adequately protect long-end rates. If the BOJ does hold steady, long-end yields will face persistent upward pressure.
A slow rate hike path is unlikely to reverse the yen's weakness; the Fed remains the dominant driver.
The BOJ is highly likely to keep rates unchanged at its Friday meeting, and the path of slow rate hikes is unlikely to change in the short term. While some board members may lean towards faster action, Governor Ueda's remarks at the press conference will be the market focus. If they are not hawkish enough, USD/JPY could test the 165 threshold. For the yen, the gap between the BOJ's slow rate hike pace and the Fed's policy expectations remains the core variable determining the direction of USD/JPY. Energy price trends and the FOMC's hawkishness will continue to dominate the pair in the coming months, rather than the BOJ's 25-basis-point hike per month. Bond market signals suggest that upward pressure on long-end yields will persist, but whether this pressure can translate into a systemic strengthening of the yen still requires a substantial acceleration in the BOJ's policy path.
(USD/JPY Daily Chart, Source: Easy Forex)
As of 10:39 Beijing time on July 29, USD/JPY was quoted at 163.66/67.