Japan’s yen surged to the strongest since March versus the dollar, after the Bank of Japan (BOJ) raised interest rates and announced plans to cut bond purchases, reigniting an aggressive rally. 

The currency climbed more than 1% against all of its Group of 10 (G10) peers, punching through the key 150 per dollar level, and adding to a rapid advance that began earlier this month in anticipation of a hawkish decision by the central bank. Japanese government bonds tumbled in the wake of the announcement, with the yield on two-year notes climbing to the highest in 15 years.

The yen has benefited in recent days from a rapid unwind in carry trades, a strategy that uses low yielding currencies like the yen to fund purchases in higher yielders such as the Mexican peso. That capitulation has seen the currency rally more than 7% from a 38-year low versus the dollar reached July 3. Governor Kazuo Ueda’s comments at a subsequent press conference on the weak yen’s inflationary impact gave traders added conviction that the yen can strengthen further.

“The rate hike does mark a substantial shift in policy where policymakers are putting greater emphasis on the longer-term inflation projections,” said Francesco Pesole, a foreign exchange strategist at ING. “This is a major development for the yen, and one that can structurally change the picture of carry-trade positioning.”

JPMorgan Chase & Co estimated on July 26 that around 40% of carry trades in G10 currencies have been unwound in recent weeks, and data published last Friday showed the biggest retreat of bets against the yen since 2011.

The yen extended its rally to as high as 149.84 versus the dollar after the release of US private employment data. The yield on benchmark 10-year bonds rose as much as eight basis points to 1.083%, while the yield on two-year notes climbed to 0.456%, the highest since 2009. Meanwhile, the Topix stock index closed 1.5% higher, led by a surge in banking shares. 

The BOJ raised its policy rate to around 0.25% from a range of 0 to 0.1%, according to its statement on Wednesday. It also said it would reduce its monthly pace of bond buying - both actions that underscored its determination to normalise policy. 

While only about 30% of central bank watchers had expected a rate hike this week, more than 90% had seen the risk of such a move, according to a Bloomberg survey. Comments from Japan’s new currency chief, who said recent yen weakness had done more harm than good for the Japanese economy, had added to the anticipation.

The initial pace of the BOJ’s cuts to bond buying was a touch slower than some expectations, but the plan looks more aggressive than other market forecasts for a halving of purchases over a two-year period.

“This must be one of BOJ’s most hawkish moves given how low it has set the standard to be,” said Charu Chanana, the head of currency strategy at Saxo Capital Markets. “Still, pressure on the yen will likely continue if the US Federal Reserve (Fed) stays away from a clear indication of a September rate cut.”

Dollar strength, stemming from the Fed keeping interest rates on hold, has been one of the biggest headwinds for the yen this year. The US central bank will conclude a two-day meeting later in the day.

While policymakers are expected to hold rates steady, traders are looking to see if Fed chair Jerome Powell signals that a cut is near. Markets are currently fully pricing a reduction in September.

“Short-term momentum can definitely see dollar-yen continuing to decline,” said Derek Halpenny, the head of foreign exchange research at MUFG, on Bloomberg Television. If Powell indicates that a September cut is indeed likely,  “that could be enough for dollar-yen to be well below 150 before the end of the week”.

BOJ governor Ueda said any additional hikes this year would be data dependent, and would be undertaken only after gauging the impact of Wednesday’s move as well as the March rate increase. 

Asked if the bank could lift rates beyond 0.5%, Ueda said, “If you are asking if we view that as a wall, we don’t really have that sense.”

  - Bloomberg