Reports indicate that the Japanese government is supporting the Bank of Japan (BOJ) in raising interest rates in the near term, with the next hike likely taking place in September or October.

Sources suggest the BOJ is concerned that a weak yen is fueling higher prices, while the government aims to strengthen the effectiveness of recent joint U.S.-Japan intervention in the currency market. As a result, both sides are aligning on the need for a rate hike in the near future.

Although the BOJ has legal independence in monetary policy, it is also required to maintain close communication with the government on key economic goals. While the government cannot force the BOJ to set a specific interest rate, it can send signals that influence its decisions.

As the effects of the first joint U.S.-Japan intervention to buy yen since 1998 begin to fade, markets increasingly expect the BOJ to join in supporting the yen. U.S. Treasury Secretary Scott Bessent has already signaled that he believes action from the BOJ is necessary.

On July 31, the BOJ decided to keep interest rates unchanged. During a press conference following the meeting, Governor Kazuo Ueda mentioned that the pace of rate hikes might accelerate, citing concerns over further upward pressure on prices. Later that day, the U.S. and Japan coordinated actions to jointly support the yen in the foreign exchange market.

Before the July meeting, the Japanese government had already conveyed to the BOJ that it would support Governor Ueda in making more hawkish comments during the press conference. Based on trader pricing, there is a 74% probability that the BOJ will raise rates at its next monetary policy meeting on September 18.

The large interest rate differential between the U.S. and Japan has been a key factor driving the yen's persistent weakness. The yen's depreciation is further fueling inflation, adding to the cost-of-living pressures in Japan.

So, what impact could a rate hike by the BOJ have? A recent strategy report from Shenwan Hongyuan suggests that the yen's future trajectory will depend on the oil price center, U.S. monetary policy direction, and the policy constraints of the Japanese government. Meanwhile, changes in the AI industry trend could amplify yen volatility through speculative positions.

Scenario 1: Benign and Gradual Yen Appreciation

If the situation in the Middle East eases, oil prices continue to fall, and U.S. inflation pressures decline, the Federal Reserve could gain room to cut rates, leading to a weaker U.S. dollar and a stronger yen. In this case, the yen would appreciate in an orderly and moderate manner, putting pressure on the U.S. dollar index. U.S. Treasury yields would fall moderately, easing capital outflows from emerging markets. Global risk assets would recover, with funds diversifying from dollar assets to other markets. The carry trade would unwind in an orderly, gradual manner, without posing a systemic shock.

Scenario 2: Sharp and Disorderly Yen Appreciation

A sharp appreciation is not driven by a fundamental revaluation but rather by the risk of a reversal of crowded speculative positions. This could be triggered by a narrowing of the U.S.-Japan interest rate differential, such as an unexpected rate hike by Japan, or rising expectations of a U.S. recession. It could also be triggered by a surge in volatility, such as a sharp drop in tech stocks causing leveraged funds to suffer both asset and exchange rate losses. Additionally, if the U.S.-Japan joint intervention overcorrects, the market could form a consensus on yen appreciation, leading to disorderly movements. In this scenario, U.S. Treasury rates would continue to rise unexpectedly, and global asset prices would fall. The carry trade would reverse, causing leveraged dollar funds to rush to unwind positions, putting broad pressure on global risk assets, including U.S. tech stocks, Japanese stocks, and emerging markets with high external debt.

Scenario 3: Continued Yen Depreciation

If the conflict in the Middle East becomes a protracted war, keeping oil prices high for an extended period, the yen's fundamentals would remain fragile. Domestically, until the Japanese government faces substantial constraints, the market will continue to expect loose fiscal policies, keeping pressure on Japanese government bonds. In this scenario, continued yen depreciation would mean a positive contribution to global liquidity, potentially benefiting risk assets. However, it would also accumulate certain vulnerabilities and risks.