Hedge funds rushed to exit short yen positions as the carry trade, once popular among investors, collapsed. Data from the U.S. Commodity Futures Trading Commission (CFTC) showed that hedge funds reduced their net short yen positions by 56,639 contracts in the two weeks ending July 23, the largest sell-off since early 2011.

While hedge funds still hold short positions on the yen, they are the least bearish since February. That marks a surprising shift in sentiment as expectations mount that interest rates will eventually tilt in the yen’s favor.

“The yen’s recent strength has been driven by expectations of a hawkish Bank of Japan decision this week,” said Win Thin, global head of foreign exchange strategy at Brown Brothers Harriman & Co. “If the Bank of Japan’s decision is disappointing, much of the yen’s rebound will be quickly reversed.”

Investors’ growing bullishness on the yen will be tested this week when the Bank of Japan and the Federal Reserve announce their interest rate decisions. Swaps imply a roughly 50% chance of a rate hike on Wednesday. Any dovish comments from Bank of Japan officials could derail the yen’s recent gains.

The yen has appreciated about 5% after Japanese authorities appeared to have taken dual intervention measures to boost the yen earlier this month. However, "It is the futures investment funds that are unwinding (short yen positions). After the Bank of Japan and the Federal Reserve make policy decisions this week, the unwinding will stop and turn in the other direction," said Shoki Omori, chief strategist at Mizuho Securities.

The Bank of Japan faces a difficult decision amid doubts about interest rate hikes

As the Bank of Japan's policy meeting approaches, all eyes are on how the central bank will balance its monetary policy in response to weak consumer spending and persistent inflationary pressures. Bank of Japan officials must find a delicate balance between maintaining economic stability and supporting the yen. Their decisions will not only affect Japan's economic outlook, but may also have far-reaching implications for global financial markets.

According to people familiar with the matter, Bank of Japan officials believe that their decision on whether to raise interest rates at this week's policy meeting has become complicated by weak consumer spending. Some officials prefer not to raise interest rates in July to give them more time to check upcoming data to confirm whether consumer spending will pick up. But there are also officials who are willing to raise interest rates at the July meeting. They believe that the Bank of Japan's policy rate range of 0% to 0.1% is very low, and given the many uncertainties in the future, they may miss the opportunity to raise interest rates.

A media survey last week showed that only about 30% of Bank of Japan watchers expect the Bank of Japan to raise interest rates at the end of this month, but more than 90% of respondents saw the risk of a rate hike.

It is worth mentioning that another key point at the Bank of Japan's policy meeting this week is the extent to which the Bank of Japan will reduce its monthly bond purchases. The survey showed that analysts expect the Bank of Japan to reduce its monthly bond purchases by 1 trillion yen to 5 trillion yen (US$32 billion) per month starting in August; in the long term, according to the median estimate, the Bank of Japan will reduce its monthly purchases to 3 trillion yen within two years.

Among analysts who do not expect the Bank of Japan to take any rate hikes this month, many say combining a rate hike with the release of a quantitative tightening path would be too big a shock and there is too much uncertainty about how the market would react to a "double move." "It is unlikely that the Bank of Japan will suddenly take bold action after spending 1.5 months finalizing its bond plan to convey its very cautious stance," said Naomi Muguruma, chief fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities.

.