Today's Focus: Japan's interest rate hike "already priced in by the market," central bank statements decide the yen's direction

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The Bank of Japan's rate hike has been fully priced in by the bond and swap markets, and investors' focus is rapidly shifting from the single interest rate decision to the central bank's guidance on the future tightening path, especially the comments by BOJ Governor Kazuo Ueda after the meeting.

Currently, market expectations are that the BOJ will raise the overnight lending rate by 25 basis points to 0.75% today, the highest level in thirty years. According to Chasing Wind Trading Desk, Nomura's Japan Rate Strategy team analyzes that, given the market has already sufficiently priced in a rate hike, the decision alone may not serve as a further catalyst for yields to rise. Nomura's global FX strategy team points out that the USD/JPY exchange rate has rebounded to around 155.50, and the yen's appreciation momentum has weakened as the rate hike expectation has been digested.

For investors, the core focus of this meeting has shifted from "whether to raise rates" to Kazuo Ueda's guidance on the pace of future rate hikes. Analysts believe that if the central bank fails to convey a tightening pace faster than market expectations, including signals on the possible terminal rate, this meeting may even turn into a "non-event" for the market.

In addition, although fiscal policy and the budget bill will enter a key window this week, considering that the Sanae Takaichi government may show a softer stance on expansionary fiscal policy and the market has already priced in rate hikes, the risk of fiscal factors sharply driving yields higher in the short term has decreased.

Rate hike expectations are fully priced in; focus on terminal rate guidance

Nomura’s Japan Rate Strategy team noted in its latest report that although it expects the BOJ to signal continued rate hikes at the December 18-19 meeting, the yen rate market seems to have already completed the pricing in advance. According to Reuters, the BOJ is unlikely to update its estimate of the natural rate (i.e. the actual neutral rate) at this meeting. Even if there is an update, central bank officials do not expect major changes to the valuation.

Against this backdrop, the market widely doubts that Kazuo Ueda will clearly state the neutral rate—as well as the terminal rate envisioned by the central bank—as significantly above the current market pricing of 1.5%. Nomura analysts Tomoaki Shishido and Tomoya Narita believe that even if Ueda reiterates at the press conference that 1.0% is not the policy rate ceiling, and that the rate remains below neutral after a hike to 0.75%, yields will not rise further as these remarks are already expected by the market.

The current consensus shows that the market is quickly forming a view that the policy rate could rise to 1.0% as early as mid-2026. Therefore, even if the central bank signals a willingness to continue hiking rates in 2026, it will not surprise the market.

Hawkish signal threshold rises: Key is “speed” rather than “magnitude”

For the foreign exchange market, a simple rate hike is no longer enough to support a stronger yen. Nomura global FX strategists, including Yujiro Goto, point out that if Kazuo Ueda wants to prevent yen selling after the meeting, the most effective way is to hint at a faster pace of rate hikes.

Since ending negative interest rate policy in March 2024, the BOJ’s average pace of hikes has been about once every seven months. Currently, overnight index swap (OIS) market pricing shows expectations that the central bank will maintain this pace and raise the rate to 1.00% by Q3 of 2026. Therefore, only if the guidance indicates the next rate hike could come earlier than this schedule (e.g., earlier than April 2026), will the market interpret it as a hawkish signal and trigger yen buying.

On the contrary, without substantially updating neutral rate estimates, the central bank governor can hardly convince the market that the terminal rate will be much higher. The current 3-year and 1-month yen swap rate is 1.60%, indicating the market has priced in the terminal rate at 1.50% or higher. Considering Japan's potential growth rate has not significantly increased, and the central bank believes it is not lagging behind the curve, Kazuo Ueda is unlikely to risk guiding the market towards excessively high terminal rate expectations.

Fiscal policy in focus

While the market spotlight is on the central bank meeting, fiscal policy trends should still be monitored. Nomura’s Japan Rate Strategy team reminds that the 2026 fiscal year tax reform outline and preliminary budget bill are expected to be finalized around December 19 and 26.

The market will pay attention to solutions for the “annual income barrier” issue. If, as proposed by the Democratic Party for the People (DPP), the income cap is removed, it may lead to a tax loss of about 5 trillion yen, which would trigger higher yields and yen depreciation. However, if the eventual loss is kept within 0.5 trillion yen, the market will consider it a favorable factor for bonds. Moreover, if actual spending in the initial 2026 budget can be kept below 122.4 trillion yen, the bond market may see it as a positive surprise; if it well exceeds 125 trillion yen, it will be a negative shock. Currently, signs show the Sanae Takaichi government’s fiscal expansion stance may be milder than previously expected.

Risk warning and disclaimerThere are risks in the market, and investments need to be made cautiously. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investments made based on this are at your own risk. ```