Rate hike bets leave yen’s post-intervention gains at BOJ’s mercy

Two weeks ago, the Japanese government and the United States collaborated to strengthen the weakened yen. This joint intervention has intensified speculation that the Bank of Japan (BOJ) will increase rates more rapidly in the future. Japan, the U.S. Treasury, and South Korea's coordinated efforts pushed the yen approximately 5% higher in late July and early August, a gain it has since failed to maintain.

However, a significant shift in expectations for U.S. interest rate hikes has added 25 basis points of anticipated rate hikes for this year, as traders believe the BOJ may finally begin supporting the currency. Currency strategist Moh Siong Sim highlights the need for a more aggressive BOJ stance, but also emphasizes the importance of validation from the central bank.

U.S. Treasury Secretary Scott Bessent played a pivotal role in initiating the intervention by urging Japan to follow up with policy and fundamentals, which was interpreted as a nudge to Prime Minister Sanae Takaichi to adopt a less dovish stance and enable the BOJ to raise interest rates. As political pressure lessens, there is a possibility that the BOJ may accelerate its rate hikes.

Currently, there is a 76% chance of a September hike, according to Tokyo Tanshi data, up from 24% on July 30. The yen's decline accelerated this year due to its long-term weakening trend driven by interest-rate differentials with the U.S. After April-May's record Japan-led intervention failed to reverse the trend, the U.S. joined to buy more yen.

The finance ministry has pledged to do so again after the July 30-31 joint operation with the U.S. Treasury, the first since 1998, that brought the currency back from a 40-year low of 163.99 per dollar. The yen has since risen to as high as 155.20, but has since returned above 159. The BOJ's role is crucial for determining the yen's stability beyond the next market test.

In the short-term, the only way to halt the yen's weakness is for the BOJ to raise rates, according to senior strategist Katsutoshi Inadome. Mizuho Securities has also adjusted their base case for the next hike to September, citing a surprisingly hawkish tone in the BOJ's July Summary of Opinions and raising their terminal rate forecast to 1.75% from 1.50%.

However, concerns about Japan's fiscal deficit and unfunded tax cuts continue to put upward pressure on government bond yields, undermining the lasting effects of intervention. As a result, the pressure is back on the BOJ. With bond yields and swap rates already pricing in a September move, a delay by the central bank would be interpreted as a betrayal of the market, leading to a loss of faith in the BOJ's ability to continue its rate hike path, potentially causing the yen to fall and longer-term bond yields to climb as inflation concerns escalate.