Following the Bank of Japan's unexpected reduction in debt purchases during routine operations this week, investors' bets that the bank will raise interest rates by the end of July are heating up.
Overnight index swaps suggest the probability that the central bank will raise interest rates by the end of July is about 70%, up from about 50% earlier this month.
The shift in market position comes at a time when the yen is facing downward pressure. The sharp spread between the US and Japan has led to a weakening of the yen. Furthermore, the market also has a growing expectation that the central bank may announce a wider reduction in debt purchases at the June meeting before raising interest rates in July.
In the Tokyo market, the yen remained stable on Wednesday, and the trend of Japanese treasury bonds was moderate. The yield on 20-year and 30-year treasury bonds recently climbed to the highest level in ten years. The benchmark 10-year Treasury yield is within easy reach of 0.975%, the highest level since 2013.
Christopher Willcox, head of the trading department at Nomura Holdings, said in an interview on Wednesday that the 10-year Treasury yield “may exceed 1% at some point” because inflation is likely to remain high.
Willcox added that the yen is still likely to rise to 140 yen per dollar this year, based on expectations that the Bank of Japan may announce “limited austerity” in October.
Investors have mixed opinions about the outlook for July and beyond.
One market indicator shows that apart from the March rate hike, traders expect the Bank of Japan to raise interest rates only once more this year.
Pimco expects the Bank of Japan to raise interest rates three more times this year. Ales Koutny, head of international interest rates at Vanguard Group Inc., is expected to raise interest rates to around 0.75% by the end of the year. Goldman Sachs Group expects the Bank of Japan to raise interest rates twice a year until interest rates reach 1.25%-1.5%.
Some investors believe that the Bank of Japan will not raise interest rates drastically because companies accustomed to ultra-low borrowing costs will cut spending. Others think ignoring interest rate hikes may cause the yen to depreciate further, thereby driving up import costs.
Tadashi Matsukawa, head of the Tokyo-based fixed income management department at PineBridge Investments Japan Co., said that if the Bank of Japan raises interest rates twice a year, the yield on medium-term bonds, especially 5-year treasury bonds, will be affected.