Bank of Japan to Raise Rates? Currency Traders’ Views Diverge

Bank of Japan Interest Rate Decision
Expected:   0.50%       
Previous:    0.25%     

How Could The Markets React? 

The majority of economists predict that the Bank of Japan will announce a 25 basis point interest rate hike at the end of its ongoing two-day meeting, but dissenting opinions have found renewed fervor following rumors that officials were more likely to stand pat. Much like we saw ahead of December’s BoJ meeting, Japanese newspapers have cited official sources as saying that rates would most likely remain unchanged until subsequent rate announcements. World financial markets clearly took the news at face value, with Japanese Government Bonds posting their largest gains in four months on the announcement. Perhaps interestingly, however, the Japanese Yen remained resilient in the face of falling bond yields—resisting a move to fresh thirteen month lows against the US dollar in the process. Subsequent outlook for the currency remains pessimistic, however, with underlying fundamental data bolstering the case for unchanged borrowing rates through the near term. Given publicly acknowledged weakness in consumer spending, the BoJ may have to wait for a more bullish run of data to support the case for higher interest rates. Likewise significant, political pressures for stable rates could tip the scales in favor of delayed monetary policy tightening, with this likely to be an election year for the ruling LDP party. All signs point to unchanged rates, but the potential of surprise underlines event risk for the Japanese currency. Indeed, overnight expected volatility stands at a whopping 13.75 percent ahead of the announcement.

Bonds – Japanese 10-year Government Bond (JGB) Future

Japanese bond yields saw their most pronounced decline in nearly four months, as rumors of unchanged interest rates sparked renewed demand for government debt. Euroyen synthetic FRA’s posted a very similar reaction to the news, as the front-month Euroyen contract rose by the most since August of last year. Given these developments, it seems increasingly likely that the world’s second-largest economy will see steady rates through tomorrow’s meeting. The potential for surprise remains, however, with overnight swaps pricing in an approximate 30 percent odds of a 25 basis point hike. Clearly, such a development would bode poorly for bond prices, but a hike could significantly bolster short-term support for the Japanese currency.

FX – US Dollar vs. Japanese Yen

Action in the USDJPY has come to a virtual standstill as financial markets around the world await the Bank of Japan’s decision on whether the time is right for another interest rate hike to back up July’s first quarter point hike. As it stands, the Japanese yen has been easily bullied through support levels against most of its liquid pairings, so potential for a sharp move accented with a decent carry through has diminished significantly. Looking to the fundamentals supporting the possible outcomes though, there is obviously a great divide. On one hand, the traditionally conservative culture is represented by a government that faces political tilling in the summer. With consumers reaping little reward from strong corporate revenues in the form of wages and benefits, consumer spending (and subsequently inflation) has floundered. On the other hand, members of the central bank’s monetary policy team has increasingly used biased language that is more common to the western world. This has generated a generous level of speculation in the currency market. Even more encouraging is the rampant speculation from the media through all forms of medium. Newspapers have debated the topic more fiercely than some politicians. Recently, the scales have tipped to the conservative crowd as market participants suspect politicians have captured the ear of BoJ Governor Fukui and his crew. Subsequently, if rates are left untouched with the typical statements finding little alteration, the resultant volatility will likely be mild with only 121 offering a form of weak psychological resistance in USDJPY. Conversely, should the less favored hike defy the markets, a corrective move could be in orders. However, the long-term implications of such a move would be more dependant on promises of future hikes rather than a 25 basis point surprise, since the a 0.50 percent overnight cash rate is still the best short on the carry out there.

Equities – Nikkei 225 Index Futures

While the currency markets are taking the BoJ’s rate decision with a grain of salt, Japanese equities are hanging on to every word of speculation. Currently, domestic firms are able to borrow at rates that are enviable for business circles everywhere else in the world. Along with stable export demand, low lending rates have been one of foundations for the longest period of growth in Japan since World War II. Now as central bankers try to acclimate the markets to the reality that rates will gradually rise, domestic investors seem concerned that the strength in Japan will end up being more fragile than expected. Just in the past few weeks, the increased media attention circling the rate decision has acted to halt a month-long advance in the benchmark Nikkei 225 Index. In the first active sessions of the year, the possibility surrounding a January rate hike hit highs not seen in futures contracts in years. This led to sharp drops in the benchmark stock index. Recently, however, as the tides turn to the dovish outlook investors are more used to, stocks have recovered. The tempered speculation surrounding a rate hike open equities up to a bigger drop should the BoJ go against he grain and take rates up to 0.25 percent. With global stock benchmarks slowing their steady ascent in tandem, a sharp turn in the Nikkei could mark the selling point in other time zones, where the warnings of overbought conditions have popped up more than once.