If the Bank of Japan adopts a dovish rate hike on Friday: the yen may fall below 158 and retest 160.

The Federal Reserve's hawkish rate hike has put pressure on the yen, and the Bank of Japan faces an unprecedented test at its interest rate decision on Friday.

The Federal Reserve announced its first interest rate hike since 2023 and signaled further tightening, prompting traders to price in three more rate hikes by mid-2020. This directly limited the potential upside for the yen from the Bank of Japan's rate hike—even if the Bank of Japan follows suit as expected, the US-Japan interest rate differential will remain high for an extended period. The yen traded around 155.98 in Asian trading on Thursday, hovering near a two-week low.

The market has largely priced in the Bank of Japan's 25-basis-point rate hike, so the focus has shifted to Governor Kazuo Ueda's post-policy press conference, where investors will look for the pace and extent of further tightening. Glenn Yin, research director at ACCM in Sydney, warned that if the Bank of Japan disappoints the market, "the risk of a short-term breach of the 160 level cannot be ruled out."

Hawkish signals from the Federal Reserve boosted the dollar, leaving the yen with little room to breathe.

The rate hike, spearheaded by newly appointed Federal Reserve Chairman Warsh, received unanimous support and clearly foreshadowed another rate hike in 2026. Interest rate futures markets indicate a roughly 90% probability of another 25 basis point rate hike this year. Driven by this, the dollar index rose to approximately 100.3, a near seven-week high; the two-year Treasury yield, sensitive to Fed policy, remained at 4.7153%, its highest level since 2024; while the 10-year Treasury yield fell to near the 5% mark.

The strengthening dollar hit the yen hardest. The yen fell as much as 1% overnight to 156.42, erasing gains made earlier this month driven by multiple positive factors, including expectations of a Bank of Japan rate hike, the unwinding of yen carry trades, and the potential for Japanese pension funds to increase their allocation to domestic assets. Hawkish signals from the Federal Reserve System led to a market repricing. Carol Kong, a currency strategist at the Commonwealth Bank of Australia, stated that the Fed's clear guidance on the future path of rate hikes "surprised the market and ultimately pushed the dollar higher."

The Bank of Japan faces a challenging signaling task.

If the expected rate hike goes ahead, it will push Japan's policy rate to a 31-year high. However, strategists generally believe that the rate hike alone is unlikely to provide sustained support for the yen. Rinto Maruyama, senior interest rate and foreign exchange strategist at SMBC Nikko Securities, a subsidiary of Mitsubishi UFJ Financial Group, points out that the anticipated rate hike will push Japan's policy rate to the lower end of its estimated neutral interest rate range. This means officials are unlikely to hint at a one-off 50 basis point hike or consecutive rate hikes. "If the market interprets this meeting as dovish, the next upside target for USD/JPY will be 158." He believes that if US interest rates continue to rise faster than Japanese rates, USD/JPY could potentially return to 160 in the long term.

Moroga Akira, chief market strategist at Aozora Bank, holds a similar view. He stated that the Bank of Japan's "stance may not be as hawkish as the Federal Reserve's, which could be a catalyst for immediate yen weakness," and considers 158.50 (approximately the 200-day moving average) as the next key resistance level.

Bank of Japan hawkish board member Hajime Takata had previously reserved the possibility of a significant or continuous interest rate hike, but Maruyama believes this option has a limited probability of occurring under the current circumstances. Kazuo Ueda's remarks at the press conference will be the core basis for judging whether this decision is "dovish" or "hawkish."

The risk of intervention has returned to the forefront, but it has become more difficult to aggressively short the yen again.

The renewed weakening of the yen has prompted the market to reassess the possibility of currency intervention. This summer, Japan and the United States coordinated their first yen intervention since 1998, with Japanese Ministry of Finance data showing that the intervention amounted to a record 15.4 trillion yen (approximately US$98.6 billion) in the month ending August 26. US Treasury Secretary Bessenter subsequently continued to signal support for a stronger yen, which to some extent dampened the market's willingness to rebuild short positions.

According to data from the U.S. Commodity Futures Trading Commission (CFTC), leveraged funds reduced their short positions in the yen in the week ending September 8. The sharp rebound in the yen had previously caused losses for carry traders, and hedge funds' net short positions have fallen significantly from their peak. In a research report, Citigroup strategists Osamu Takashima and others pointed out that the USD/JPY pair may rebound to 159 in the short term, but "it is becoming increasingly clear that the pair has reached a significant top this summer." Repeated currency interventions and the increased attractiveness of Japanese government bond valuations are driving the exchange rate into a new phase of mechanism transformation.

Nevertheless, given the Fed's clearly hawkish stance and rising expectations of policy divergence between the US and Japan, the risk of two-way volatility in the yen before and after this decision should not be underestimated. The market will closely watch Kazuo Ueda's wording regarding upside inflation risks and the future path of interest rate hikes at the press conference.

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