Japan’s economic comeback faces hardest BOJ test in a generation

Japan’s transformation from sleeping economic giant to magnet for growth and investment is set to face its fastest sequence of interest rate hikes since the bursting of Tokyo’s asset bubble more than a generation ago.

Amid a wave of pressure from U.S. Treasury Secretary Scott Bessent, chronic weakness in the yen and prices that keep going up, the Bank of Japan looks set to raise benchmark borrowing costs for the third time in less than 10 months at its meeting on Friday. That would mark the fastest pace of interest rate hikes since 1990, when Japan was still seen as a rival to U.S. global economic dominance.

Four outsize rate increases in less than a year back then brought the Tokyo stock market to its knees and marked the beginning of the nation’s descent from overheated growth into economic stagnation. This time around Japan is on a more modest growth path and the most obvious dangers lie in the currency and bond markets.

One potential fault line runs from the yen into the U.S. Treasury market, and from there into higher loan repayments for American businesses and consumers. Another threat comes from any sharp rise in yields for Japanese government debt. This would reverberate globally and also make it harder for Japan to fund Prime Minister Sanae Takaichi’s $2.4 trillion investment package to get the country back in the economic fast lane.

Yet if the BOJ can deliver a rate hike while managing market expectations for further increases, it may preserve a nascent recovery in the yen, nudge inflation closer to target and ensure an orderly rise in bond yields.

“The September meeting has become crucial,” said James Athey, a London-based fund manager at Marlborough Investment Management with over 20 years of industry experience. His fund is still betting on the yen to strengthen, but sees some in the market needing little encouragement to sell the currency.

“The BOJ needs to hike and deliver a more forceful message lest they undo all the work done so far,” Athey said.

Failure to deliver a hike now would put the BOJ at odds with Bessent, and jolt markets that are primed for further increases in coming months. | Bloomberg

Much will depend on Gov. Kazuo Ueda’s performance at the post-decision news conference, which comes late in the afternoon in Tokyo at a critical point in the day as the center of gravity in currency trading shifts from Asia to Europe.

The yen, which remains significantly weaker than its average over the past decade, has advanced close to 6% since late July, when Tokyo started its latest round of intervention to bolster the currency. The U.S. also weighed in, helping Japan prop up the yen for the first time in 28 years, and upping the stakes for speculators.

Failure to deliver a hike now would put the BOJ at odds with Bessent, and jolt markets that are primed for further increases in coming months. The transactional nature of U.S. President Donald Trump’s administration, and the forcefulness of comments from his Treasury secretary, have even led to suggestions that the U.S. and Japan struck a deal that included a near-term rate hike.

“I am the house now, so when we intervene with the Japanese yen, I have pretty good insight into what the Japanese, what the Bank of Japan is going to do, what Japanese policymakers are going to do,” Bessent said last week. “And you can bet against me if you want.”

Japan spent a monthly record of ¥15.4 trillion ($100 billion) on the intervention and appears to have funded a portion of this by selling Treasuries. Another turn downward in the currency that forced Japan to sell Treasuries again would add to upward pressure on U.S. yields and could prove painful for Republican politicians heading into November’s midterm elections.

A sixth rate increase by the BOJ under Ueda — the most by any governor in at least half a century — is almost fully priced into the market for overnight index swaps. They point to the policy rate rising by a quarter point to 1.25% on Friday and peg the probability of another increase by late December at more than 80%.

Beyond the market positioning, this also reflects deepening perceptions that Japan is relinquishing its decades-long role as an outlier in monetary policy that anchored low global yields.

“The BOJ is ending its gradual normalization,” said Chotaro Morita, chief strategist at All Nippon Asset Management. “This has major implications for the future rate path.”

Board member Kazuyuki Masu reiterated the central bank’s upward trajectory Thursday.

“The Bank will continue to raise the policy interest rate” given that financial conditions remain very easy, Masu said in a speech to business leaders. “What is most vital from now on is to ensure that the underlying inflation rate does not significantly exceed 2%.”

BOJ Gov. Kazuo Ueda will hold a news conference Friday after a much anticipated rate hike. | Bloomberg

While Japan’s core inflation rate of 1.8% hardly seems to call out for faster rate hikes, it is been held down by the Takaichi’s government energy subsidies. Economists warn that long lasting weakness in the yen and high oil prices from conflict in the Middle East are fueling inflationary pressure that may push the gauge toward 3% later this year.

“Bessent may be talking too much about the BOJ, but he has a point: The BOJ is falling behind the curve,” said Seisaku Kameda, a former BOJ chief economist. Kameda, now executive economist at Sompo Institute Plus, sees a good chance of a follow-up hike in December after this week’s expected move.

The perception of BOJ slowness hasn’t been helped by Takaichi herself. Her government appears ready to go along with a September hike, but it remains unclear how receptive the Prime Minister will be to further moves. While Takaichi’s thinking has softened since she characterized rate hikes as “stupid” before she became leader, she is still very focused on stoking economic growth and avoiding any swoon in stocks.

The Nikkei 225 measure of blue-chip Japanese stocks is around double the level of summer of 2024, but the valuation of equities is nowhere near the extremely stretched levels seen in 1989.

Japanese stocks traded at 70 times earnings during that extraordinary boom, which some analysts described as “the biggest bubble in human history.” The Nikkei currently trades at about 21 times earnings and the broader Topix index is around 17 times.

“Compared with 1989, Japanese stocks are trading at reasonable valuations from a global investor’s perspective today,” said Tomochika Kitaoka, chief equity strategist at Nomura Securities.

“The market crashed when long-term interest rates rose above 6%,” he said, contrasting the circumstances with much lower rates now. “About half of Japanese companies are net cash, so the negative impact from higher interest rates won’t be that significant. Companies should be able to cope with a moderate rise in interest rates.”

Takaichi’s vision for Japan rests on the economy staying on a growth path, underpinned by new budget dynamics that mimic the U.S. She wants to focus on controlling the ratio of debt to the size of the economy, instead of simply balancing the books.

This involves inflation helping to push up the size of gross domestic product in nominal terms and boosting tax receipts to create more room for spending.

“The economy is likely to keep recovering moderately even if the BOJ raises rates this week,” said Yoshiki Shinke, senior executive economist at Daiichi Life Research Institute. While business spending is sensitive to borrowing costs it’s unlikely overall capital spending will drop when companies need to invest in labor saving technology and AI, he said.

“Still, Japan’s economy hasn’t had this kind of steady rate hike cycle for a long time, so we really need to watch carefully to see at what point the weight of rate hikes hits the economy,” he said.

The rub from this inflation is higher bond yields that translate into bigger debt-servicing burden. These costs account for a quarter of Japan’s annual budget and the Finance Ministry projects they will increase by almost a third to ¥41.3 trillion in 2029.

The implications of higher yields in Japan also affects international money flows. For many years, the nation’s biggest investors have built enormous portfolios of global stocks and bonds. Meanwhile, foreign funds have dived into carry trade strategies that involve borrowing cheaply in yen and putting the proceeds to work around the world.

“If domestic yields continue to rise, Japan may gradually retain more capital at home,” said Ales Koutny, head of international rates at Vanguard Asset Management Ltd.’s active funds. “That matters not only for the yen and JGBs, but also for Treasury markets, European bond markets and broader global funding conditions.”

This might not result in a wholesale shift of overseas investments back to Japan, but it may limit the amount of money flowing abroad, and help support the yen.

Marlborough’s Athey said “the big underestimation” is how quickly the yen could appreciate if and when conditions align for Japanese life insurers, pension funds and banks to reevaluate the case for stashing money overseas.

Vanguard’s Koutny goes further.

“The story is not really about whether the BOJ hikes once more or twice more,” Koutny said. “The more important question is whether Japan is transitioning from being a supplier of global liquidity to a stronger competitor for global capital.”