Analysis:Yen rally faces moment of truth as BOJ risks disappointing markets

The Bank of Japan (BOJ) faces a critical juncture as the sharp yen rally comes under scrutiny. After surging 5 percent against the dollar in early September, the yen reached a near seven-month high of 152.89 per dollar. Speculation about Japan's $2 trillion pension fund repatriating funds to invest domestically fueled the rally.

However, analysts warn that the market may be disappointed when the BOJ makes its policy decision on Friday, as the bank risks disappointing markets with a more hawkish tone than anticipated. The market is pricing in unrealistic expectations of a 2 percent terminal rate, which could harm the Japanese economy. Additionally, the prospect of the Federal Reserve tightening policy, following recent inflation data, may further bolster the dollar against the yen.

Analysts suggest that the yen's rally may be unsustainable, as the BOJ's hawkish rhetoric could be cancelled out by parallel tightening from the Fed. Furthermore, Japan's worsening terms of trade, driven by its heavy reliance on imported oil due to the U.S.-Israeli war on Iran, could contribute to a reversal of the yen's gains. Speculation surrounding Japan's Government Pension Investment Fund (GPIF) reinvesting more domestically has also subsided, as the fund's 10-year bond yields have surged to a 30-year high.