Japan's interest rate hike sparks disagreement: Hawkish or dovish? Capital flow reversal imminent

On December 19th, the Bank of Japan will announce its interest rate decision, with the market almost certain to raise rates by 25 basis points to 0.75%. However, the market’s true focus is not on the rate hike itself—since this has already been fully priced in—but on Governor Ueda and his hints regarding the future trajectory of rate increases.

Policy Shift Behind the Rate Hike Hints

The Bank of Japan may adjust its assessment of the neutral interest rate. Currently, the natural rate estimate is rising, which suggests that the central bank’s estimate of the lower bound of the neutral rate could be raised from 1.0%. The market generally prices in that Japanese interest rates will rise to 1.0% by September 2026.

However, there are clear disagreements among institutions. Nomura Securities believes the market’s expectations for the rate hike path are overly optimistic. In contrast, U.S. banks provide a more aggressive forecast—under a “hawkish rate hike” scenario, the yen exchange rate will face significant support.

Arbitrage Trade Closure: The “Black Swan” of Crypto Assets

The most direct impact of Japan’s rate hike will occur in the foreign exchange market. Once large-scale USD/JPY arbitrage trades are closed, funds will rapidly flow back from U.S. stocks, cryptocurrencies, and other high-risk assets to Japan, triggering a chain reaction.

The situation at the end of July 2024 is a typical example—when the Bank of Japan unexpectedly raised rates to 0.25%, carry trades reversed, the yen appreciated sharply, and U.S. stocks and Bitcoin came under downward pressure.

However, analysts point out that the impact of this rate hike on the market should be more moderate. On one hand, the market has already fully priced in the rate hike expectations; on the other hand, Japan is still implementing large-scale fiscal stimulus policies, which will continue to suppress the yen.

Exchange Rate Trends: Divergence in Institutional Forecasts

Two major institutions have very different outlooks for USD/JPY.

U.S. banks tend to interpret this as a “dovish rate hike,” believing that the Bank of Japan will adopt a cautious stance, and that USD/JPY will remain high. They project target prices for 2026 as 160 (Q1), 158 (Q2), 156 (Q3), and 155 (Q4). If a “hawkish rate hike” occurs, short covering of the yen could push it down to around 150, but this scenario is considered less likely by these institutions.

Nomura Securities is more optimistic, noting that yen depreciation is increasing domestic political pressure in Japan. As the U.S.-Japan interest rate differential narrows, the attractiveness of yen arbitrage trades will gradually decline. They forecast USD/JPY target prices for 2026 to decline each quarter—155 (Q1) → 150 (Q2) → 145 (Q3) → 140 (Q4).

How Investors Should Respond

Whether the rate hike expectations materialize as priced by the market will determine the short-term trend of risk assets. Paying close attention to Ueda’s wording, especially guidance on the future frequency of rate hikes, will be key to judging the next market volatility.