Rate Hike? QT? Will the Bank of Japan perform a "hawkish" script on Wednesday?

The Bank of Japan launched its highly anticipated monetary policy meeting for July on Tuesday. Wall Street expects the Bank of Japan to keep interest rates unchanged but announce a Quantitative Tightening (QT) plan to gradually reduce bond purchases.

On Wednesday morning, July 31st, the Bank of Japan will announce its July interest rate decision, followed by a press conference by Bank of Japan Governor Haruhiko Kuroda.

Although most of Wall Street expects the Bank of Japan to maintain the status quo, there is still anticipation for a possible rate hike. Analysts at ING predicted in a report last week that the interest rate (upper limit) could be raised from the current 0.1% to 0.15%, while Bank of America and JP Morgan expect rates to go as high as 0.25%, an increase of 15 basis points.

JP Morgan noted that the market anticipates a 40% chance of a rate hike in July, but if the Bank of Japan chooses not to raise rates, the yen interest rate may experience more active fluctuations.

Citigroup pointed out that if the Bank of Japan's interest rate decision in July meets market expectations, the Japanese stock market will not experience significant volatility, and the yen to dollar exchange rate is expected to return to the low of 165 yen in the coming months. Previously, influenced by expectations of a rate hike, the yen to dollar exchange rate surged and is currently hovering around 154.

"Virtuous Cycle" Not Yet Formed, Bank of Japan Unwilling to Risk Rate Hike

According to media reports, Bank of Japan Governor Haruhiko Kuroda stated in June to the parliament that the central bank may raise interest rates based on "economic, price, financial data and information at that time."

Currently, Japan's CPI in June was 2.8%, unchanged from May, while the core CPI excluding fresh food prices accelerated to 2.6% from 2.5%. The overall inflation rate has exceeded the Bank of Japan's 2% target for over two years.

The so-called "core of the core" CPI (excluding fresh food and energy prices) – a key indicator for the Bank of Japan to measure inflation, rose from 2.1% to 2.2%.

Despite inflation reaching or even exceeding the Bank of Japan's target rate, the central bank has been focused on confirming whether inflation is in a "virtuous cycle," where higher wages continue to drive price increases.

The Japanese Trade Union Confederation (Rengo) stated on July 3rd that large companies with 300 or more union-supported employees have raised wages by 5.19%, while small companies have increased by 4.45%. The union claimed that this is the largest wage increase in thirty-three years Nomura Securities' latest report pointed out that although there have been gradual changes in the corporate sector such as rising wages and prices, household spending has not responded sufficiently to wage growth, failing to further push up commodity prices, indicating that wages and prices are still forming a "virtuous cycle."

Nomura Securities expects the Bank of Japan to keep its policy rate unchanged at the upcoming monetary policy meeting, a view shared by Citigroup.

Citigroup believes that if the Bank of Japan decides to maintain the interest rate, the subsequent outlook report and monetary policy press conference may convey increased confidence in the inflation outlook based on wage increases and rising inflation expectations.

If the upcoming data meets expectations, the Bank of Japan may explicitly state that a rate hike in September is appropriate.

How specific is the QT plan?

The Bank of Japan stated in June that it would reduce the scale of purchasing Japanese government bonds "to ensure that long-term interest rates are more freely formed in the financial markets."

It is widely expected in the market that the Bank of Japan will gradually reduce the scale of long-term bond purchases, with expectations to decrease to a pace of 3 trillion yen per month over the next one to two and a half years.

According to data released in March, the Bank of Japan currently purchases around 6 trillion yen (39 billion US dollars) of Japanese government bonds per month, with media calculations showing that as of July 19, the total amount of Japanese government bonds held by the Bank of Japan is as high as 579 trillion yen.

Media reports citing sources mentioned:

The Bank of Japan may gradually reduce its bond purchases in several stages, at a pace roughly in line with the market consensus, to avoid an unwelcome surge in yields.

J.P. Morgan also pointed out that if the Bank of Japan's announced QT plan is more hawkish than market expectations, it could lead to a narrowing of swap spreads along the curve.

Citigroup's forecast is more aggressive, estimating that over the next one to two years, the Bank of Japan may plan to gradually reduce Japanese government bond purchases to around 2 trillion yen per month.

Nomura Securities believes that regardless of the scale and pace of reduction, the key is to provide transparency to ensure that reducing central bank bond purchases does not unexpectedly exert upward pressure on yen rates