Monetary tightening in Japan has not been easy for the BoJ. It has to be cautious that higher rates don’t prompt a return to the deflationary mindset that so constrained the activity of consumers, in particular since the bursting of the property/equity bubble in 1990.

The BoJ also has to ensure that rate hikes do not lead to a financial rout, spurred by the rapid unwinding of the large, but unquantifiable, yen-funded carry trade. Ensuring minimal economic and financial market strains has not always proved possible. The announcements of rate hikes in March and July 2024 and again in January 2025 all corresponded with a period of significant yen strength and often with a slump in riskier global assets, like stocks.

These experiences highlight the fact that financial markets are very sensitive to BoJ rate hikes, as they can seem to spur a rapid, if temporary unwinding of the yen-funded carry trade. This not only lifts the yen sharply but can undermine the assets that go to make up the other side of the yen-funded carry trade. So, as we approach a likely 25-bps rate hike on Friday, the market seems right to be nervous.

However, Steven Barrow, Head of Standard Bank G10 Strategy, said that such nerves are unwarranted for a number of reasons. The first simply relates to timing. The rate hike, if it happens, will come so close to the holiday season that it won’t spur wholesale changes in investor positioning.

A second issue is that, from what we can tell, the yen-funded carry trade has already been trimmed quite a bit.

For instance, Commodity Trading Futures Commission (CFTC) data on the open positions of speculative traders shows that these traders are net long in the yen to the tune of some 50k contracts right now. Usually, in periods where there is a high concentration of yen-funded carry trades, these speculative accounts would be very short. For instance, speculative traders had been short of as many as 180k yen contracts in July 2024 when the BoJ hiked rates. This probably helps explain why that rate hike produced a surge in the yen and a slump in global stocks.

A third factor is that a 25-bps rate hike is pretty much fully priced into the market for Friday’s meeting. This was not the case for the rate hike we just described in late July 2024. This being said, it might be the case that the Bank could produce what is regarded as a ‘hawkish hike’ if, for instance, Governor Ueda were to make it clear that the Bank still has some way to go to get policy back to an appropriate or more neutral setting, but we doubt that he will say that.

A final point Steven Barrow would make is that the initial yen strength generated by BoJ rate hikes has not persisted. The yen’s effective exchange rate is around 8% lower now than when the BoJ started to hike in early 2024. In other words, while rate hikes may provoke carry trade unwinds, investors soon seem to re-enter short-yen positions. This would seem to be for one or two reasons.

The first is that the rate hike is simply insufficient to dent the allure of holding overseas assets funded by yen borrowing. This is particularly likely if other central banks have been hiking as well, as many did in 2021 and 2022.

A second factor, in Steven Barrow’s view, is that longer-term yen weakness persists despite rate hikes because there is something fundamentally unattractive about the yen that goes beyond carry-trade considerations. He thinks this likely reflects concerns over the government’s huge level of debt, the fiscal dominance over monetary policy that this implies, and the potential debasement of the yen that results.

In other words, even if BoJ policy rates were significantly higher than today’s levels, it is not clear that the yen would be any stronger. In fact, the fiscal problems created by much higher rates, via increased debt-financing costs, could even make BoJ rate hikes counterproductive when it comes to generating yen strength.