China Merchants Bank (CMB) released a research report noting that on December 19, the Bank of Japan (BOJ) raised its policy rate by 25 basis points (bp) to 0.75%, in line with market expectations. The decision was unanimously supported by all nine board members, marking the highest policy rate since 1995. This hike follows the BOJ's previous rate increase in January 2025, ending an 11-month pause.
Market reaction remained muted as the move was anticipated. Japanese equities continued their upward trend, while the 10-year Japanese government bond (JGB) yield edged higher. The yen weakened to around 156 against the dollar post-hike, reflecting a "buy the rumor, sell the fact" dynamic, with other markets showing limited response.
**Policy Outlook: Gradual Tightening** The BOJ opted for a rate hike amid persistent inflation and yen depreciation pressures. Japan's CPI inflation hit 3.0% in November, leaving real rates deeply negative. Meanwhile, USD/JPY breached 156, prompting the central bank to curb one-sided currency weakness. CMB expects the BOJ to maintain a cautious pace, likely hiking twice annually (25bp each) through 2026, lifting rates to 1–1.5%.
Inflation drivers—primarily food, utilities, and labor shortages from aging demographics—are supply-side dominant, reducing sensitivity to rate hikes. Economically, Q3 contraction reflected trade war impacts on exports and investment. Fiscal sustainability has improved, with government leverage falling 16 percentage points (pct) to 215% (2020–2025), potentially declining further to 200% in five years, aided by high nominal growth outpacing debt expansion.
**Risks to Watch** Despite measured tightening, yen liquidity shifts and JGB risks may strain global financial conditions: 1. **Yen Carry Trade Unwind**: ~$9 trillion in yen-funded positions could gradually shrink as U.S.-Japan rate differentials narrow. However, current net short yen positions have significantly reduced versus July 2024 levels, likely softening market disruption. 2. **JGB Pressures**: Near-term fiscal stimulus (2.8% of GDP) and long-term defense/GST plans risk exacerbating debt concerns. Steeper yield curves may emerge, tightening financial conditions. Coupled with trade war shocks and sticky inflation, Japan risks stagflation, further straining fiscal health.
**Asset Implications** - **JGBs**: Rates face upward pressure, especially at the long end, amid debt-inflation spirals. - **Yen**: Limited sustained strength expected; BOJ’s dovish stance and debt worries may keep it range-bound. - **Equities**: Short-term liquidity headwinds offset by global AI/tech investment tailwinds; stocks likely to grind higher.
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