Capital outflow and yen depreciation double pressure, the probability of the Bank of Japan being forced to raise interest rates in January increases?

Despite entering a new year, Japan remains trapped in last year's policy dilemma of the "impossible trinity," with intensified capital outflows compounded by the Bank of Japan's dovish stance, making the depreciation of the yen potentially larger and harder to predict.

Bank of America pointed out in a report on January 9 that Japan is currently mired in a policy trilemma, where a country cannot simultaneously achieve the following three goals: free capital movement, exchange rate stability, and an independent monetary policy.

In 2024, Japan faces this dilemma, as the NISA (Nippon Individual Savings Account) policy implemented at the beginning of the year accelerates capital outflows, and the Bank of Japan adopts a gradual normalization of monetary policy. These factors collectively lead to the depreciation of the yen, making it the worst-performing currency among G10 currencies in 2024.

The fate of the yen under this year's policy trilemma is even harder to predict. In January, retail capital outflows set a new record, and combined with the Bank of Japan's previous dovish stance, Bank of America believes the yen's depreciation will be larger and harder to predict, thereby increasing the likelihood of interest rate hikes. If USD/JPY exceeds 160, the probability of a rate hike in January will exceed 55%.

Retail Capital Outflows Set New Records, Bank of Japan Maintains Dovish Stance

Retail capital outflows have set a new record, with Bank of America stating:

In January 2025, Japanese retail investors net invested approximately 600 billion yen in foreign stock-related investment trusts (Toshins), marking the fastest monthly growth rate ever. On January 8, the single-day net inflow was about 400 billion yen, setting a new single-day record. The sharp increase in investment at the beginning of the year is attributed to retail investors attempting to fill their annual NISA quota through one-time investments to fully utilize tax benefits.

This rapid capital outflow trend reflects Japanese household investors' efforts to cope with rising domestic inflation and yen depreciation by diversifying investments to protect their wealth from the impacts of emerging inflation and yen depreciation.

Meanwhile, the Bank of Japan maintained its dovish stance in December, with Bank of America pushing back expectations for the next rate hike from January to March:

BoJ Governor Kazuo Ueda's dovish remarks when USD/JPY was above 155 surprised the market, indicating limited concern from the BoJ regarding the level of yen depreciation. The market interpreted this as the BoJ prioritizing the stability of the interest rate market and stock market over the foreign exchange market.

The accelerated capital outflow and the Bank of Japan's dovish stance have led to discrepancies in the pricing of the USD/JPY exchange rate and the January 23-24 monetary policy meeting of the Bank of Japan, with the market pricing in less than a 50% probability of a rate hike in January. If USD/JPY significantly rises above 160, it may increase market expectations for policy responses.

Yen Depreciation Larger and Harder to Predict, Rate Hike Probability Exceeds 55% if Below 160

Bank of America predicts that USD/JPY will be higher and more unpredictable, with the market's judgment on the exchange rate threshold for policy intervention likely having risen, making the specific levels difficult to predict due to the following factors:

Unstable government: The government of Shintaro Ishihara, supported by a parliamentary minority coalition, appears unstable. We are concerned that an unstable government may lack consensus on monetary policy and allocate fewer resources.

Uncertainty of U.S. policy: U.S. policy under the new Trump administration remains uncertain. For Japanese policymakers, it may be more difficult to proactively intervene in financial markets before the U.S. policy stance is clarified.

Bank of Japan's reaction function: The market needs to reassess the BoJ's policy reaction mechanism, increasing uncertainty.

Bank of America further stated:

Although the foreign exchange threshold level for policymakers remains uncertain, the market may increase pricing for policy responses when USD/JPY rises above 160, especially after the exchange rate further breaks through 162, which will lead to greater volatility.

In our view, if USD/JPY exceeds 160, the likelihood of an interest rate hike will exceed 55%. It may also correct some of the recent steep rises in the 10-year Japanese Government Bond (JGB) curve.

Additionally, key events that may influence USD/JPY before the Bank of Japan's January policy meeting include the Bank of Japan branch managers' meeting on January 9 (today), the U.S. non-farm payroll report on January 10, a speech by Bank of Japan Deputy Governor Masayoshi Amamiya on January 14, and developments in U.S. policy around Inauguration Day on January 20