Bank of Japan shrinks its balance sheet, "arrow on the string" as fate of interest rate policy remains uncertain, market uneasy

According to the Wisdom Financial APP, Bank of Japan Governor Kazuo Ueda will announce the detailed plan for Quantitative Tightening (QT) on Wednesday, which has kept investors highly vigilant. In addition, he may also stack rate hikes to double down.

According to a survey by Bloomberg, although only about 30% of Bank of Japan observers predict a rate hike as the base scenario, almost no one rules out the possibility of a rate hike. The high level of uncertainty is driving the yen and Japanese stocks to fluctuate like a roller coaster, and this volatility may continue until before or even after the Bank of Japan makes a decision.

Informed sources revealed that some Bank of Japan officials are open to the idea of a rate hike this month as inflation remains broadly in line with expectations. Others believe that staying put and waiting for more data and signs of a recovery in consumer spending is also an option for the Bank of Japan.

All of this indicates an unusually worrisome meeting, where the central bank governor may ultimately set the policy course by exerting his own will. This decision will have an impact on the global markets, as the yen exchange rate is currently at a turning point, potentially continuing its significant rebound this month or falling back to multi-decade lows.

The Federal Reserve will hold a meeting a few hours after the Bank of Japan meeting, and signals about U.S. interest rates could greatly amplify market volatility that began in the Asian trading session or cause a rapid reversal.

Ko Nakayama, former Bank of Japan official and current Chief Economist at Okasan Securities, said, "This is a difficult decision for the Bank of Japan. A rate hike would indicate the central bank's strong desire for policy normalization and that Japanese authorities will act when necessary without haste."

Pricing in the swap market shows a 50% probability of a 15 basis point rate hike by July 31, up from 25% a week ago.

Another key event of this meeting will be the announcement of the first plan to reduce bond purchases. After more than a decade of large-scale monetary easing, the Bank of Japan finally ended this trend in March this year and embarked on the path of Quantitative Tightening (QT).

The aforementioned sources said that Bank of Japan officials have no intention of cutting bond purchases in a way that would disturb the market, and they are very clear about market expectations. The market unanimously believes that starting next month, the monthly pace of bond purchases will be reduced from the current 6 trillion yen to 5 trillion yen (32 billion U.S. dollars), ultimately halving over two years.

Bank of Japan observers who do not expect a rate hike this week often use the announcement of the bond plan as an example. These observers state that taking preliminary action on Quantitative Tightening alongside a rate hike may result in excessive tightening for the Japanese economy, which has not shown much growth in the three quarters leading up to March

In addition, the trend of the Japanese yen after the Bank of Japan's decision is another major factor that the bank may consider, especially after the suspected intervention in the foreign exchange market by the Japanese Ministry of Finance earlier this month.

The yen exchange rate has been fluctuating continuously, as traders unwind positions focused on the Japanese-US interest rate differential, causing the yen to rise from a 38-year low to a two-month high within a month. The significant appreciation of the yen last week led to a reevaluation by investors of their leveraged bets, pushing up the renminbi exchange rate and causing a ripple effect on assets from Japanese stocks to gold and bitcoin.

On July 3, the USD/JPY exchange rate once soared to 161.95, but as of the time of writing on Monday, the rate was 153.38.

The recent appreciation has reduced the necessity for the Bank of Japan to correct the weakness of the yen. Daisuke Karakama, Chief Market Economist at Mizuho Bank, stated that this is a good time for a rate hike as the Bank of Japan can argue that the rate hike is unrelated to the exchange rate.

Karakama said, "This meeting may be much easier to raise rates now. Otherwise, the central bank may once again be pressured by the weakness of the yen to take action. This may be a key moment for the yen to shift from a trend of significant depreciation."

Observers of the Bank of Japan still vividly remember when Kikuo Iwata triggered a yen depreciation in April, showing indifference to the yen's weakness at the press conference following the decision announcement. Shortly after, the yen surged, leading to suspicions of intervention by Japanese authorities through buying yen. Even if there is no rate hike this Wednesday, it is expected that Iwata will hint that the time for another rate hike is approaching.

Recently, Toshimitsu Motegi, Secretary-General of the ruling Liberal Democratic Party, and Taro Kono, Japan's Minister of Digital Economy, called on the Bank of Japan to tighten policy to support the yen and curb inflation, contradicting the inclinations of politicians. The two emphasized more on the growing frustration brought by the yen's increasing cost of living.

Due to severe inflation, the approval rating of Japanese Prime Minister Fumio Kishida's cabinet has also been affected. For 27 consecutive months, Japan's inflation rate has equaled or exceeded the Bank of Japan's 2% target, while during this period, wage growth has consistently lagged behind price growth. Consumer spending has been declining every quarter in the 12 months leading up to March this year.

How these political calls will affect the Bank of Japan's decision remains to be seen. Nakayama of Okasan Securities stated that this may also have the opposite effect, prompting the Bank of Japan to choose to stand pat this month to avoid appearing influenced by these calls.

Nakayama said, "For the Bank of Japan, the effective approach is to inquire behind the scenes, and politicians must know this. If they are serious, they will do so. So I think the recent remarks are more for show or to send a warning to the market to prevent yen depreciation On June 18th, Katsuo Ueda stated in the parliament, "The policy interest rate is likely to be raised, depending on the data and information on the economy, inflation, and financial conditions." However, since mid-June, Katsuo Ueda has not publicly discussed monetary policy, marking his longest silence before a policy meeting, making it even more difficult for the market to interpret the possible outcome of this meeting