The Bank of Japan is expected to make its largest interest rate hike in 18 years. Will this have a major impact on the market?

Recently, the monetary policy trends of the Bank of Japan have attracted much attention from the global financial market. The latest news shows that the Bank of Japan plans to further raise the policy interest rate at the monetary policy meeting held on the 23rd and 24th, and it is expected to be raised from the current 0.25% to around 0.5%, the highest level since the 2008 financial crisis. At the end of July last year, the yen interest rate hike caused a sharp drop in the global financial market. Will the trend continue to repeat this time?

The market turmoil caused by the previous yen rate hike

Last year, the Bank of Japan raised interest rates twice, completely bidding farewell to the era of negative interest rates.

On March 19, 2024, the Bank of Japan adjusted its policy rate from -0.1% to between 0% and 0.1%. After the announcement of the rate hike, the Japanese stock market experienced some fluctuations, with the Nikkei 225 Index and the Topix Index falling in the short term. Global capital markets, including the crypto market, have experienced significant fluctuations.

On July 31, 2024, the Bank of Japan raised interest rates again, from 0% to 0.1% to 0.25%. The global financial market experienced dramatic fluctuations, and the yen-dollar exchange rate once soared by 0.4% to its highest level in 7 months, and many markets in the Asia-Pacific region fell sharply. Among them, the Nikkei 225 index fell by more than 12%, the largest drop in history; the Korean Composite Index fell by more than 10% during the session, triggering a circuit breaker, and European and American stock markets also fell. Bitcoin fell all the way from $60,000 to $49,000, a daily drop of about 15%, and Ethereum fell by 23%, and the market was wailing.

Why does the Japanese yen have such a great influence?

As the world's largest carry currency, changes in the Japanese yen's interest rate policy have a profound impact on the global financial market. For a long time, due to Japan's ultra-low interest rates, the Japanese yen has become the preferred currency for international capital seeking high-yield financing. Investors borrow Japanese yen at low cost and invest in high-yield assets such as US bonds, US stocks, cryptocurrencies or assets in other high-yield countries to earn interest rate spreads.

The interest rate hike will cause the yen to appreciate rapidly in a short period of time. Take the "Black Monday" caused by the last interest rate hike in Japan as an example. After the Bank of Japan suddenly raised interest rates, borrowing costs increased, market liquidity decreased, and the stock market fell. If investors used cheap yen to finance investment in high-yield markets before, they will not only have to bear the decline of high-yield assets, but also face losses caused by the appreciation of the yen exchange rate. When investors sell US dollar assets to repay yen debts, the price decline of financial assets such as US stocks is further exacerbated. At the same time, due to the liquidation of carry trades, a large amount of funds flowed back to Japan, further pushing up the yen exchange rate, bringing more pressure to close yen positions, forming a vicious circle.

Will this rate hike continue to replicate the previous trend?

In financial markets, expectations are the forerunner of behavior. The Bank of Japan’s previous interest rate hike was not in line with market expectations. At the time, the market generally expected the current interest rate to remain unchanged, so when the unexpected rate hike occurred, market panic increased significantly.

The impact of this rate hike on the market may be relatively limited. On the one hand, the Bank of Japan has fully communicated with the market to avoid unexpected changes in monetary policy. With continued leaks and market expectations, market uncertainty has decreased. On the other hand, compared with July 2024, the current market's net short position in the yen is not at an extreme state, so the possibility of a reversal is not great. In addition, the relatively strong US economy has also reduced market concerns about a global recession, which has helped stabilize market sentiment.

As the interest rate differential between the United States and Japan gradually narrows, carry trades may decrease and the pressure on the yen to depreciate may ease. This will help improve the competitiveness of the Japanese economy, attract more international capital to flow into the Japanese market, and boost the Japanese stock market.

Although the market has fully anticipated the interest rate hike, the interest rate hike itself may still bring certain fluctuations to the market. Therefore, investors should pay close attention to market reactions and use more flexible and efficient trading tools to cope with market changes.