Bank of Japan Outlook: Rate Hike Likely to Support Yen

Following recent bouts of support for the yen, the Bank of Japan seems likely to raise its benchmark interest rate to 1.25% at its meeting on Sept. 17-18. If rates aren’t changed, we think the yen’s recent rise could unwind, after the BOJ and US Treasury Department reportedly jointly spent over $100 billion to bolster the currency.

We think the BOJ is comfortable with the yen at around the 150 level, but a level that threatens 170 appears to be a larger concern. This supersedes concerns the BOJ may have of high interest rates destabilizing Japan’s financial sector.

BOJ on a Gradual Rising Rate Path

The BOJ raised its benchmark interest rate to 1% at its recent June meeting. The bank has gradually raised interest rates by 75 basis points since July 2024.

We generally believe the BOJ prefers a gradual rate rise because more than 70% of corporate loans and 75% of mortgages are on floating rates. The end of cheap lending rates in Japan will add pressure to borrowers. At this stage, the pass-through to mortgages is somewhat contained by a 25% rise limit on borrowers, but this will eventually catch up.

A couple of factors are hurting the yen in the short term. The prospect of US interest rates staying higher for longer puts pressure on the yen if the differential in yields between Japan and the United States widens. There has also been less domestic confidence and demand for the yen. Japanese entities and individuals are switching out of the yen to mitigate its weakness. We also think rising interest rates leave the yen carry trade (wherein foreign entities borrow in yen for global use) less attractive.

Watching JGB Yields

We expect the yen to average 150 in our five-year forecast for the Japanese exporters under our coverage, in line with guidance from most of those companies. One of the reasons we believe the yen may not rebound to its pre-covid level of 100-110 in the next few years is that we think the market may remain wary that Japanese government bond yields will stay high as the government issues more bonds to fund fiscal activity while the BOJ reduces its JGB purchases to contain inflation and rebalance its balance sheet.

The unwinding of the carry trades may continue to see yen sales. In addition, Japanese banks such as Mitsubishi have sold down JGBs to diversify capital holdings. Domestic outflows from the yen may therefore continue over the next few years.

But some strengthening is possible in 2027. We expect the BOJ to gradually raise interest rates to 2% through 2028. With our expectation for US interest rates to reverse as the economy slows in 2027, we should see the differential between the two countries’ bond yields narrow.

Japanese financials have been a key beneficiary of the rising domestic lending rates. One of the banks we like best is Resona, and we expect its return on equity to improve to 12% by March 2030 from the 5%-9% range seen in the past five years. But we feel the market has largely factored in improvements to banks’ profitability from the rate rises, and share prices are currently not attractive versus risk.