Investors have fallen over each other in recent weeks to buy the yen on bets that interest rates are finally about to tip in Japan’s favour. They face a moment of truth next Wednesday.

The currency is holding onto an advance of about 5% against the dollar since just before it began surging on July 11, in a move that was amplified by suspected intervention by Japan. Some investors warn that the rally is fragile, as was on show when the yen rapidly retraced gains after stronger-than-expected US economic growth figures.

Swaps markets on Friday suggested a 45% chance of the Bank of Japan (BOJ) hiking rates by 15 basis points by the conclusion of its July 31 policy meeting, indicating plenty of caution. And only 30% of BOJ watchers surveyed by Bloomberg forecast a hike, even if more than 90% see it as risk. 

That leaves yen bulls vulnerable, particularly if the BOJ also disappoints expectations for a sizeable cut in bond purchases, or if the Federal Reserve later in the day does anything to damp hopes for rate cuts in the US in coming months.

“This is a crazy yen rally,” said Nick Twidale of ATFX Global Markets, who has traded Japan’s currency for a quarter of a century. “The BOJ could be party poopers and not play their part in tightening policy.”

Twidale said that if the BOJ underwhelms the market, carry trades that have kept the yen weak “may come back with a vengeance”.

Others from BlackRock Inc to former central bank officials are predicting the BOJ will stand pat on interest rates for longer. 

Patchy economic data lend credence to this view: while a key gauge tracking the strength of Japan’s service sector rebounded in July, a measure of factory activity showed a contraction. Weak consumer spending is further complicating the BOJ’s decision next week, people familiar with the matter say. 

“If BOJ does nothing, the dollar-yen rate could surge again,” said Amir Anvarzadeh, a strategist at Asymmetric Advisors who has tracked Japanese markets for over three decades.

The yen swung between small gains and losses on Friday. It was up 0.2% at 153.65 per dollar at 2.29pm in Tokyo, after inflation figures for Tokyo earlier showed that consumer prices accelerated for a third month.

Nathan Swami, the head of foreign exchange trading for Asia-Pacific at Citigroup Inc in Singapore, saw additional demand for bullish yen options after the outsized move this week.

“It is still too early to tell if this signals a longer-term investor sentiment shift, and may thus more likely be a tactical shift in short-term positioning or hedging activities for now,” he said.

According to other traders, some hedge funds remained on the sidelines, amid uncertainty over how much the currency could gain ahead of next week’s BOJ policy meeting.

If the BOJ “doesn’t fully deliver”, then the yen could weaken towards the 158 level against the dollar, according to National Australia Bank Ltd’s Rodrigo Catril. 

Yet even if the BOJ does tighten policy on Wednesday, there is still a case for it to retain favour in carry trades, in which investors take advantage of Japan’s ultra-low interest rates to borrow in yen to then invest in currencies with higher yields.

The yen’s implied yields would still be about 90 basis points lower after a hike than those for the Swiss franc, which is an alternative funding currency for carry trades. 

US rates risk also abound. Should the odds of Fed rate cuts retreat, Japan’s currency could come under attack once more.

“The yen can test 160 if the Fed doesn’t signal a September rate cut and US data starts to strengthen again,” said Charu Chanana, the head of currency strategy at Saxo Capital Markets. 

  - Bloomberg