The Impact of Monetary Policy and Political Dynamics in Japan

In October, the Japanese yen saw a significant weakening against both the U.S. dollar and the euro. This decline is largely attributable to the Bank of Japan’s (BoJ) continued accommodative monetary policy. After implementing some adjustments in July—including reducing Japanese Government Bond (JGB) purchases and raising the interest rate on excess reserves slightly—the BoJ chose to keep its stance unchanged in October. These adjustments were designed to keep short-term interest rates low and stable. However, Japan’s relatively low rates, especially in comparison to the U.S., have added downward pressure on the yen, making it less attractive to investors seeking higher returns.

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 Source: Finlogix ChartsThe U.S. economy’s strong performance has further widened this gap. Over recent months, the U.S. has released consistently positive economic data, from strong job numbers and robust retail sales to persistent inflationary pressures. These indicators have supported higher U.S. yields, driving investors to the dollar over the yen and intensifying yen weakness. Additionally, speculation around potential U.S. political shifts—particularly regarding a possible Trump re-election—has led to expectations of stronger U.S. trade policies. Many market participants believe that a Trump administration could introduce more aggressive trade stances, which would likely strengthen the dollar further against other currencies, including the yen.

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 Source: TradingViewOn Japan’s side, the BoJ has recently hinted at a more “hawkish” stance. While the central bank has not made concrete rate hikes, it has signalled a readiness to tighten monetary policy if Japan’s economy meets its growth and inflation targets. Currently, I’m expecting the BoJ might raise rates by late 2025, though there is a chance this could happen sooner if inflation and economic growth remain stable.

Japan’s Political Landscape and Its Influence on Economic Policy

Japan’s political environment has also influenced its economic outlook. Following a recent election, the ruling coalition led by Prime Minister Ishiba lost its majority in the lower house of Japan’s parliament. This shift has created uncertainty around the government’s ability to pass key economic policies without forming new alliances. To secure the necessary support, the coalition may consider expanding its base by forming a partnership with the Democratic Party for the People (DPP).

If an alliance with the DPP is formalized, it could lead to new economic initiatives, such as increasing tax-free income thresholds for part-time workers, which would benefit consumer spending. While these policy shifts may provide some support to Japan’s economy, they are unlikely to directly alter the BoJ’s monetary strategy in the near term. However, by smoothing the legislative path for economic reform, a coalition with the DPP could indirectly support earlier rate adjustments if Japan’s economic indicators continue to improve.

Interest Rate and Yield Outlook

In October, Japan’s 10-year JGB yield climbed to 0.95%, reflecting both global bond market trends and domestic currency depreciation. This rise in yields indicates that investor sentiment is increasingly factoring in future rate hikes by the BoJ. The BoJ’s cautious shift toward a more hawkish stance stems partly from easing inflationary pressures, alongside the persistent strength of the U.S. economy, which keeps international bond markets buoyant.

Japan’s labour market has also shown promising signs, with moderate wage growth seen as an important step toward achieving stable inflation. The BoJ regards sustained wage increases as a critical factor for reaching its 2% inflation target, as higher wages boost consumer spending and economic resilience. If Japan’s labour market continues to strengthen, it could accelerate the BoJ’s timeline for rate hikes, especially if inflation trends remain favourable.

Additionally, there is speculation that the U.S. dollar might stabilize or even weaken if the U.S. economy achieves a "soft landing," in which inflation cools without causing a major downturn. Should this scenario unfold, demand for the dollar could decrease, potentially reducing the downward pressure on the yen. A more stable yen would ease inflationary risks in Japan, allowing the BoJ more flexibility in timing any potential rate hikes.

In summary, while Japan’s domestic monetary policy remains largely supportive of economic growth, external factors like U.S. economic strength, evolving trade expectations, and Japan’s political landscape are increasing the likelihood of a shift in the BoJ’s policy stance. Should inflation and economic growth remain steady, the BoJ might consider rate adjustments earlier than the market currently anticipates. This scenario would mark a notable pivot from Japan’s traditionally ultra-loose monetary policy, driven by a confluence of internal resilience and external pressures.

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