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Analysts expect the trend of unwinding short yen positions to dominate ahead of the Bank of Japan's policy decision next week.

After a long period of unilateral depreciation against the US dollar, the trend of the Japanese yen against the US dollar seems to have reversed since mid-July. In the early trading of Asia Pacific today (July 25), the Japanese yen against the US dollar rose above the 153 mark for the first time since early May.

Market expectations for the Bank of Japan's interest rate decision next week, coupled with Japan's recent suspected intervention in the foreign exchange market, have led investors to close their yen carry trades. However, whether the yen bearish sentiment will return ultimately depends on the Bank of Japan's interest rate decision next week.

Yen rises to more than two-month high against dollar, euro

So far in July, the Japanese yen has reversed its previous decline and become the best performing G10 currency. In early trading today, the dollar hit 153.10 yen, the lowest level since May 6.

The possibility of another rate hike in Japan and recent rounds of suspected foreign exchange intervention have caused speculators to close carry trades with the yen as the funding currency. On July 21, according to data from the U.S. Commodity Futures Trading Commission (CFTC), leveraged funds reduced their net short positions in the yen by 38,025 contracts last week, the largest since March 2011. Asset management companies also cut their short positions in the yen, the largest in a year.

Yukio Ishiuki, senior foreign exchange market strategist at Daiwa Securities in Tokyo, said there is little demand to sell the yen after a series of interventions by Japanese authorities in the foreign exchange market. He expects the trend of closing short yen positions to dominate ahead of the Bank of Japan's policy decision next week.

According to market speculation, the Japanese authorities may have intervened in the market at a total cost of 5.64 trillion yen in two trading days on July 11 and 12, after the yen fell to a more than 40-year low against the dollar earlier this month. On July 11, the yen recorded its largest single-day gain against the dollar since May 1. That evening, Japanese Finance Ministry Vice Minister Masato Kanda said he could not comment on whether Japan intervened in the foreign exchange market. Yusuke Miyairi, a foreign exchange strategist at Nomura International, said that the fact that Masato Kanda was able to speak to the media so late in Tokyo time was "very telling."

In addition to intervention, the short-term bearishness of the dollar due to investors' belief that the Federal Reserve will cut interest rates as early as September has also contributed to the yen's rebound. However, the yen still faces a big test at the end of this month, when both the Federal Reserve and the Bank of Japan will announce their interest rate decisions. Any dovish hints from the Bank of Japan could be a reason to resume shorting the yen. Yujiro Goto, head of foreign exchange strategy at Nomura Securities, said: "Whether the situation in the yen market has changed, the answer is yes, but in the long run, it is too early to judge now."

Some analysts have also begun to firmly believe in the rebound of the yen. For example, Jonas Goltermann, deputy chief market economist at Capital Economics, said that the US-Japan interest rate differential may continue to shift in favor of the yen, and the yen is expected to rise further to 145 against the dollar by the end of this year. Brian Daingerfield, foreign exchange strategist at National Westminster Capital Markets Bank, also said: "Even if the statement issued by the Bank of Japan next week is not as hawkish as the market currently expects, the Japanese Ministry of Finance may still take action to prevent the yen from weakening. Another reality is that the Federal Reserve seems to be close to starting an easing cycle."

In the view of some analysts, in addition to the US dollar, the trend of the yen against the euro also seems to be a potential trigger for Japan's intervention in the foreign exchange market.

Earlier this month (July 11), the euro hit 175.43 yen, the highest level since the euro was created in 1999. Citigroup warned in a research report at the time that the euro accounts for about 20%-30% of Japan's foreign exchange reserves. After multiple interventions in the US dollar, Japan may also reduce its euro reserves to avoid an imbalance in distribution. If the euro-yen exchange rate approaches 180, Japan is likely to intervene in the foreign exchange market and sell the euro. Immediately afterwards, on July 12, the Bank of Japan conducted an exchange rate check on the euro. Exchange rate checks usually occur when volatility increases and verbal interventions do not seem to be enough to curb exchange rate fluctuations. The last time the Bank of Japan conducted an exchange rate check was in September 2022, and it intervened in foreign exchange a few days later. The euro-yen also fell back to around 171. In early trading today, while the dollar hit a new low in more than two months against the yen, the euro-yen also hit 166.13, the lowest level since May 8.

Markets focus on Bank of Japan's interest rate decision next week

In addition to foreign exchange intervention, the main factor leading to the recent reversal of the yen's trend against the dollar and the euro is that the market is betting that the Bank of Japan will be "hawkish" at its policy meeting on July 30-31. On Wednesday, people familiar with the matter said that the Bank of Japan may debate whether to raise interest rates when it meets next week and announce a plan to roughly halve bond purchases in the next few years, indicating the Bank of Japan's determination to steadily withdraw from its massive monetary stimulus policy.

People familiar with the matter told the media that there are currently two main opinions among officials of the Bank of Japan: some officials propose to keep on top of policy in July and wait until consumer spending data rebounds significantly before making a decision, which can also avoid giving the public an overly hawkish image of the central bank; other officials, considering that current inflation is basically in line with expectations, are open to raising interest rates in July, and are worried that there are many uncertainties in the future. If they do not raise interest rates in July, they may miss the opportunity to raise interest rates again this year.

Japan’s economic data is indeed mixed. Japan’s core inflation rate reached 2.6% in June, exceeding the Bank of Japan’s target for more than two consecutive years, and Japan’s basic wages in May also reached the highest increase in 30 years since 1993, enough for the “hawks” to believe that the conditions are now suitable for another rate hike. Before the meeting next week, Japan’s Ministry of Health, Labor and Welfare decided on Wednesday to increase the national average minimum wage in Japan by about 5% to 1,054 yen (about $6.85) per hour in this fiscal year, a record increase. However, Japan’s recent weak consumption data and household consumer confidence index have also convinced the “dovish” that the Bank of Japan needs to wait for more data to determine whether tax cuts and wage increases can boost consumption as expected.

Four people familiar with the Bank of Japan's thinking said the rate decision will depend on how long committee members are willing to wait to see whether consumption will recover and inflation will stabilize around the bank's 2% target. "It is clear that the Bank of Japan is likely to raise rates in the coming months. It is just a matter of time," one of them said. Another source said: "For the Bank of Japan, there is still a long way to go to exit quantitative easing. Even if the rate is raised again this time, Japan's monetary conditions will still be very loose."

More than three-quarters of economists polled by Bloomberg News expect the Bank of Japan to remain on hold this month, with the next move likely to be in September or October. Economists surveyed said that while the nine-member committee generally agrees on the need to raise rates in the near term, there is no consensus on whether to do so next week or later this year.

The Federal Reserve will also hold an interest rate meeting on the same day. Given the decline in U.S. inflation and slowing economic growth in recent months, the market expects that the Federal Reserve is likely to send a stronger signal of a rate cut in September.

More certain than the prospect of a rate hike is that the Bank of Japan will announce detailed plans on how to reduce its bond purchases at its July meeting. Sources said the Bank of Japan may gradually reduce its bond purchases in stages, at a pace roughly in line with mainstream market expectations, to avoid a rapid and sharp surge in Japanese bond yields. The Bank of Japan held three meetings with bond investors from July 9 to 10. During the meetings, investors had different opinions on the extent and speed of reducing bond purchases, but overall the market expects the Bank of Japan to roughly halve its monthly bond purchases from 6 trillion yen per month to 2 trillion to 3 trillion yen within the next year and a half to two years. This reduction will reduce the proportion of Japanese government bonds held by the Bank of Japan to GDP by 13% and 17% respectively in two years. Compared with the Federal Reserve, the Bank of Japan's reduction is smaller in absolute terms, but faster in relative terms.

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