Bank of Japan Rate Decision (JUN 14) (TBA)
Expected: 0.50%
Previous: 0.50%

How Will The Markets React?

Japanese bond and FX markets have grinded to a halt ahead of the Bank of Japan’s next rate decision, as the event has the potential to trigger the much fear carry trade unwind. Though there is no official time of release, the information tends to hit the new wires just after 23:30 EST on the release date. For the past four months, the Bank of Japan has kept interest rates unchanged at 0.50 percent - by far one of the lowest overnight lending rates amongst developed countries - after hiking the benchmark 25 basis points back in February. The Bank's neutral stance has not been entirely surprising after CPI has consistently indicated that the Japanese economy is still dangerously close to deflation. In fact, Tokyo core CPI (excluding fresh food and energy) fell -0.2 percent on an annual basis, marking the third consecutive month of contracting prices. Nevertheless, BOJ Governor Toshihiko Fukui said after the May monetary policy meeting, ”We will adjust interest rates gradually based on the pace of improvement in the economy and prices,” signaling that an upturn in inflation could trigger policy tightening. Furthermore, confidence by central bankers that the economy has recovered, especially as first quarter GDP was revised higher, has brought the interest rate curve to price in one rate hike by the end of the year. The question is: will it be sooner than the markets think? We don’t believe that the central bank has a chance of doing so in June, and while the probabilities are higher for a July rate increase – when the Semi-Annual outlook will be released – the LDP elections could interfere with the unpopular move.

Bonds – 10-Year Japanese Government Bond Futures

Prices on JGB’s have plummeted over the past week – similar to global government bonds – as optimistic growth outlooks and hawkish central banks have pushed both short term and long term yields higher. However, JGB declines have taken a breather at 130.76, the lowest levels reached since July 6th, 2006. Is this the end of the line for the trend? If the Bank of Japan decision keeps in line with expectations, quite possibly. Without the impetus of a rate hike or even rate hike expectations, there is little reason for yields on JGB’s to be driven higher, as the central bank’s target rate is likely to remain one of the lowest amongst industrialized nations for much of the year. However, if the BOJ aims to prove their independence from the government in order to pursue rate normalization sooner rather than later, JGB prices could break down clear through support to target 130.46.

FX – NZD/JPY

One of the most lucrative carry trades available in the FX markets – the NZD/JPY – has been at a standstill over the past few days and holding within a fairly tight range of 90.50 – 93.00. Traders are likely very hesitant to enter positions (or exit, for that matter) ahead of the Bank of Japan’s next rate decision. Far and wide, the central bank is anticipated to leave rates steady at 0.50 percent, which has done nothing but help weaken the low-yielding Japanese yen. However, given the higher revisions to first quarter GDP and increasingly hawkish commentary by BOJ policy makers, there is a slight risk that the central bank will jump the gun and take the target rate up to 0.75 percent. With LDP elections scheduled for July, BOJ Governor Fukui may seek to avoid the political pressures associated with implementing unpopular monetary policy. While a surprise hike would have major implications on the Japanese economy, the Japanese yen could easily breakout and contribute to a major unwinding of carry trade, and NZD/JPY in particular could plunge towards support at 87.00. Nevertheless, we do not expect such policy action, and high-yielding pairs such as the NZD/JPY will likely remain profitable.

Equities – Nikkei 225 Index

Japanese stocks dropped, paced by property developers and utility companies, after rising bond yields increased concerns that higher borrowing costs will erode profit growth and reduce the appeal of dividend payouts. Meanwhile, commodity producers suffered after prices of nickel, copper and crude oil fell, helping to push the Nikkei 225 Stock Average down 0.2 percent to 17,732.77. Sumitomo Metal Mining Co., Japan's biggest nickel producer, slid 4.2 percent to 2,620 while Mitsubishi Materials Corp., the nation's third largest copper producer, declined 1.8 percent to 646. On the flip side, exporters reversed their earlier losses after the yen dropped to the weakest since 2002 against the dollar and fell against the euro. Canon, the world's biggest maker of digital cameras, added 0.6 percent to 7,190 after plunging 1.4 percent earlier.

Japanese equities should fare well during the next session given the gains in US shares on Wednesday, however, the following day could prove to be treacherous with a Bank of Japan decision looming on the horizon. While the central bank is anticipated to leave rates steady at 0.50 percent, hawkish commentary from BOJ Governor Fukui and upward revision to first quarter GDP have helped to spur speculation of a surprise hike. Such an unexpected decision could send the Nikkei 225 plummeting towards ascending trendline support, and if we see a sustained break of this level, far more precipitous declines could be in store for the index. Nevertheless, given tepid CPI data that sits dangerously close to the edge of deflation, the BOJ will likely find it far more prudent to leave their target rate steady. As a result, Japanese equity traders would breathe a sigh of relief that they’ve escaped another month without a carry trade unwind and the Nikkei 225 could surge back up to the 18,000 level.

Terri Belkas is a Currency Analyst for FXCM.