It’s a very busy week full of big risk events. Three of the major central banks meet with the Bank of Japan first up, early on Wednesday. This could be the most important in terms of volatility and near-term price action, especially regarding USD/JPY and the yen carry trade which has caused ructions in broader financial markets in recent weeks.
Key starter questions include if this will be the BoJ’s second rate hike of the cycle after the bank raised its target rate back in March? Will the BoJ cut back on government bond purchases and, if so, how? Out of 46 forecasters on Bloomberg within consensus, only nine expect a rate hike. Markets are assigning a much higher probability to a 10bps hike of around 60-70% odds.
BoJ conundrum
The case for hiking rests entirely upon gauging the degree of the BoJ’s confidence that it is durably on the path toward achieving 2% inflation over the medium-term horizon, while getting further distance away from the near-zero policy rate of 10bps.
The sluggish economy and concerns about weak consumer demand could justify the need for caution, particularly when inflation, whilst above target, is far from being rampant. In fact, Tokyo core CPI just reversed prior progress toward firmer readings which sends a cautious signal. Moreover, the yen’s impressive rebound in July has potentially provided policymakers some breathing space on the urgency of rate hikes.
Interestingly, regarding wages, there is little evidence that Japan is escaping the grips of falling real wages. While the annual Shunto rounds of negotiations with unions has grabbed the headlines and driven a sharp acceleration of wage growth over the past two years, economists say this has affected less than 20% of Japanese workers so the spill over into lifting wages elsewhere is limited. Oil prices have ebbed somewhat of late but more importantly have been broadly trending sideways through much of the year. This is significant for Japan as it is an energy importer so pass-through effects are reduced.
Market reaction
The implications for global financial markets on the BoJ decision could be quite impactful. A rate hike could add further strength to the yen and would be disruptive to the carry trade. That trade has been upended due to narrowing rate differentials between Japan and US.  The carry trade is where investors used cheap Japanese borrowing costs to fund purchases of higher yielding currencies and assets. The influence of the decision on markets could also depend upon Governor Ueda’s guidance. Unchanged rates with more cautious guidance could take some steam out of the yen and motivate buying of higher yielding bonds abroad, potentially also helping stock markets rebound.
Even if there are no major surprises on Wednesday and the only announcement is the expected decision on scaling back bond purchases, it’s unlikely that policymakers would risk sounding too dovish as this could derail the yen’s recovery. The bank’s latest outlook report may offer some additional clues on the future policy course in such a scenario. For USD/JPY, 152 is a huge level of support. Resistance above current prices sits at the 100-day simple moving average at 155.54 and a near-term Fib retracement level at 155.71.
