【MACRO Alert】Expectations of interest rate hikes in Japan soar - pushing both bond yields and the ye

Recently, the dynamics of Japan's economy and financial markets have attracted widespread attention. The hawkish remarks of the Bank of Japan and the continued high inflation are pushing Japanese bond yields to multi-year highs, and also triggering market expectations of interest rate hikes. This has largely shaken the market's previous general belief that Japan's economy will not significantly increase interest rates due to severe deflation.

Mitsubishi UFJ Morgan Stanley Securities released a forecast on Monday, predicting that the Bank of Japan will raise interest rates from the current 0.5% to 0.75% in July, which is much earlier than the previous forecast of October to December. In addition, the agency also brought forward the time for the Bank of Japan to raise interest rates to 1.0% to January 2026, compared with the previous forecast of the last quarter of 2026. This adjustment shows that the market's expectations for continued growth in price pressures are becoming more and more obvious.

Given the Bank of Japan's growing concern about the risk of excessive inflation, there is a possibility of a rate hike at the meeting on April 30-May 1. And the recent rise in Japanese bond yields suggests that “the next rate hike by the Bank of Japan may come sooner than expected, and the market may have begun to price it in.” In fact, as the market reassesses the path of the Bank of Japan's rate hike, Japanese government bond yields have risen significantly.

The benchmark 10-year Japanese government bond yield rose 2.5 basis points to 1.375%, the highest level since 2010; the 5-year Japanese government bond yield also rose 3.5 basis points to 1.040%, the highest level since 2008.

The Bank of Japan raised its short-term interest rate to 0.5% in January and said it was ready to raise rates further, arguing that the economy was on track to achieve its 2% inflation target on a sustained basis. In addition, the Bank of Japan analyzed in its quarterly report released on January 24 how the long-term labor shortage has led to a rise in wage-driven inflation, which also provided a strong reason for further rate hikes .

Hawkish signals from the Bank of Japan have led markets to price in about an 80% chance of a rate hike to 0.75% in July.

A private sector survey showed that most economists expect the next rate hike to come in the second half of this year. Makoto Sakurai, a former Bank of Japan board member who maintains close ties with current policymakers, said he expects the Bank of Japan to raise interest rates to at least 1.5% over the next two years. The International Monetary Fund believes that Japan's natural interest rate is between 1% and 2%, with a median of 1.5%, and predicts that the Bank of Japan will raise interest rates to around that level by the end of 2027.

In the U.S., a drop in retail sales in January rekindled bets on a rate cut by the Federal Reserve and suggested the yield gap between the U.S. and Japan will narrow further. The yen has been the best performer among its G10 peers against the dollar this year, a sharp reversal from four years of consecutive declines. Still, the yen faces headwinds from Japanese retail investors thirst for overseas stocks and negative real interest rates in Japan. In addition, investors are getting more creative in how they bet on diverging interest rate trends in major economies, looking for ways to avoid dollar fluctuations and instead use European currencies to fund bets on the yen.

The uncertainty that Trump's trade tariff plan has brought to the market is testing dollar-based strategies, and investors are questioning whether Trump's proposal will be a driving force for the dollar's strength or just a negotiating tactic. As another way to bet on a stronger yen, some companies are using strategies involving European currencies rather than the dollar to profit from the widening exchange rate gap with Japan. Such as shorting the euro, Swiss franc and pound sterling against the yen. This is because they are considered to offer greater returns and are safer than betting on the increasingly unpredictable dollar.

The dynamics of Japan's economy and financial markets indicate that the Bank of Japan may accelerate the pace of interest rate hikes to cope with inflationary pressures. The market's expectations for interest rate hikes continue to rise, driving up bond yields and strengthening the yen. At the same time, investors' interest in the yen has increased, and asset management companies' bullish sentiment on the yen has reached a four-year high. Against the backdrop of increasing global economic uncertainty, the Bank of Japan's policy adjustments will have an important impact on the Japanese economy and global financial markets. In the future, the market will continue to pay attention to the Bank of Japan's policy trends and its further impact on the yen exchange rate and bond market.