Analysis:Yen rally faces moment of truth as BOJ risks disappointing markets

TOKYO, Sept 15 : The fate of the sharpest yen rally in 18 months rests on the Bank of Japan breaking free of its cautious rate-hiking path, though it risks a sharp reversal if the currency again succumbs to the forces that dragged it to 40-year lows in July.

A sudden, more hawkish tone to central bank rhetoric at the start of the month — with U.S. Treasury Secretary Scott Bessent calling on the BOJ to "do the right thing" — triggered a blistering 5 per cent surge in the yen against the dollar.

Yen buying was reinforced by growing speculation that Japan's $2 trillion government pension fund might lead the repatriation of large amounts of capital to invest it at home.

But following the yen's climb to a nearly seven-month high at 152.89 per dollar last week on bets that the BOJ will double the pace of rate hikes to once per quarter — climbing above 2 per cent a year from now versus 1 per cent at present — analysts say risks are heavily skewed towards a market disappointment at Friday's policy decision.

"Even if the BOJ hikes this time, it will be hard for the BOJ to be more hawkish than what the market expects," said Masafumi Yamamoto, chief currency strategist at Mizuho Securities in Tokyo, while flagging the risk of a retreat toward 157 yen per dollar.

"The market is pricing in too much. Above 2 per cent for the terminal rate is too high. It will damage the Japanese economy."

And a ramp-up in bets for Federal Reserve tightening, following inflation data last week that showed a broadening of price pressures, threatens to bolster the dollar at the yen's expense.

YIELD GAP

The market now sees a Fed hike on Wednesday as a near certainty, with rates then rising once per quarter over the next 12 months, meaning that the hawkish BOJ wagers that have boosted the yen are "totally cancelled out," Yamamoto said.

Both central banks tightening policy in parallel should keep the yield gap on 10-year bonds at a gaping 200 basis points — one of the fundamental drivers of yen weakness against the dollar for much of the past decade.

Another is Japan's worsening terms of trade, with the country's dependence on imported oil underscored by the U.S.-Israeli war on Iran.

The stage could be set for traders to rapidly rebuild positions in so-called carry trades, where investors borrow cheaply in Japan to buy higher-yielding assets elsewhere, following a massive unwinding during the yen's rally.

SHORTS FLUSHED

By one measure, those trades stood at a record high at the start of the month.

In the aftermath, speculative positioning in the yen flipped to be net long for the first time since February, according to the latest Commodity Futures Trading Commission data.

However, analysts take the flushing out of many of those positions as a bearish signal for the yen, because it creates room for speculators to rebuild short positions.

And with optimism over U.S.-centred AI trades still intact, Japanese money is also likely to continue to flow to Wall Street, the analysts said.

Japanese investors made their biggest shift toward overseas equities in five months in August, pouring 1.3 trillion yen ($8.4 billion) into foreign shares, the finance ministry's monthly dataset showed on September 8.

However, some investors are now positioning for an expected flow of funds into Japan that could amount to hundreds of billions of dollars.

PENSION PIVOT

Speculation that Japan's Government Pension Investment Fund (GPIF) could be preparing to invest more heavily in domestic stocks and bonds swirled last week after it released the minutes of a recent meeting of its governing board.

Commentators pointed to the unusual timing of the meeting — during the summer holidays — and the fact that "the basic portfolio" topped the agenda. Discussions on the same topic in March concluded that no review was necessary.

What had changed in the interim was that Japan's benchmark 10-year bond yields had soared some 100 basis points to higher than 3 per cent for the first time in three decades. And in July, both Prime Minister Sanae Takaichi and Finance Minister Satsuki Katayama called on pension funds to invest more at home.

A GPIF spokesperson declined to comment on the speculation, but said the fund assesses its portfolio annually.

Analysts, though, generally consider market expectations to be overblown, in terms of both the likelihood and impact of any allocation changes.

GPIF's governance framework requires it to minimize its impact on the market, meaning that any shift would be spread out over a period of months.

Koichi Sugisaki, Morgan Stanley's head of Japan macro strategy, said that any repatriation would "only be a temporary flow, much like forex intervention," and would not alter fundamentals that point to a yen rate of 167 per dollar.

That is if the repatriation story even plays out.

Even with Japanese yields standing at around 3 per cent, returns would fall well short of the GPIF's target return of 1.9 per cent plus nominal wage growth, which Morgan Stanley puts at between 3 per cent and 3.5 per cent.

"GPIF has little incentive to increase its allocation to domestic bonds," Sugisaki said.