Japan's interest rate hike imminent, retirement funds shifting from overseas to domestic market, will the era of a cheap yen come to an end?

The Japanese Yen has been depreciating since the beginning of 2021, with the USD/JPY exchange rate breaking through the 160 mark in July this year. However, in recent days, the Yen has strengthened significantly, appreciating by over 4% in just one month. Is the Bank of Japan (BOJ) considering raising interest rates? Is the era of a weak Yen coming to an end?

Japan Escapes Deflation, Welcomes Inflation

While the U.S. and Europe are concerned about the impact of inflation on the economy, Japan has long been plagued by deflation. Now Japan has finally emerged from the shadow of deflation. The Tokyo inflation data, which is seen as a leading indicator of inflation in Japan, shows that the core consumer price index (CPI) in Tokyo rose by 2.2% year-on-year in July, climbing for the third consecutive month, deepening market expectations for a rate hike by the Bank of Japan.

The national CPI in Japan also continues to rise. According to data from Finance M Square, the CPI in Japan was 2.8% in June, with core CPI at 2.6%.

Will Japan Announce a Rate Hike This Week?

The Bank of Japan (BOJ) announced the end of negative interest rates in March this year, and in the June meeting, it announced the beginning of balance sheet reduction. BOJ Governor Haruhiko Kuroda stated that if the underlying inflation, considering CPI and broader price indices, accelerates towards the expected 2%, they will raise the current near-zero interest rates. The Bank of Japan will hold a policy meeting on Tuesday and Wednesday this week. Is there a chance of further raising the policy rate?

There is a divergence in the market regarding whether the Bank of Japan will further raise the policy rate. The recent strength of the yen has led to speculation that the Bank of Japan may delay the rate hike because a stronger yen would lower the prices of imported goods in Japan, thereby slowing inflation. However, many Japanese politicians are calling for further tightening of policy to address the weakness of the yen. The depreciation of the yen has made imported products such as food and energy more expensive, leading to public discontent.

According to senior forex traders, there are two views in the market currently. One is to raise the benchmark rate by 10 basis points with a minor reduction in bond purchases; the other is not to raise interest rates but to significantly reduce bond purchases. However, both scenarios signal monetary tightening.

Yen Strengthens Recently, Is the Era of Cheap Yen Over?

Due to Japan's long-standing low-rate policy, investors have used it as a tool for carry trade, which is one of the main reasons for the long-term depreciation of the yen. The yen started depreciating in 2021, with the USD/JPY exchange rate breaking the 160 level several times in July. Japan intervened in the forex market in May to prevent further depreciation of the yen.

Note: Carry trade refers to borrowing in a low-interest-rate country like Japan and exchanging it for the currency of a higher interest-rate country like the U.S. to earn the interest rate differential.

The exchange rate of the yen against the Taiwanese dollar has also rebounded from the previous low near 0.2 to above 0.21. Is the era of cheap yen coming to an end?

Senior forex traders indicate that there are reports in the market of Japanese pension funds actively selling overseas assets and repatriating them back to Japan. After all, Japanese stocks have been soaring for the past two years, and not investing their own pension funds domestically would be hard to justify. This will help boost the appreciation of the yen.

If the Bank of Japan raises interest rates while the Federal Reserve in the U.S. starts a rate-cutting cycle later, the narrowing of the U.S.-Japan interest rate differential will also support the yen's strength. However, as the interest rate differentials between the two countries are still significant, the extent of the yen's appreciation in the short term may be limited.

Is the era of cheap yen officially over? It can only be said that the historical lows of the yen have raised concerns for the Bank of Japan and the government, affecting the lives of the Japanese people. With the monetary policies of Europe and the U.S. on the verge of a shift, it may be difficult for the yen to continue depreciating in the long term.

This article is not investment advice, please DYOR.