JPY strengthens as BoJ rate hike expectations & fiscal risks in focus

JPY: BoJ policy expectations & fiscal risks remains key drivers for yen

The yen has continued to strengthen during the Asian trading session resulting USD/JPY falling to a fresh low of 154.35. It leaves the yen on track to record its second consecutive week of gains against the US dollar. The yen has benefitted this week from building expectations for the BoJ to resume rate hikes this month. Those expectations have been supported overnight by a Bloomberg report stating that BoJ officials are ready to raise interest rates providing there’s no major shock to the economy or financial markets in the meantime, according to people familiar to the matter. The report adds that the BoJ will also indicate it will continue to raise rates if its economic outlook is realized while remaining cautious on how far they will eventually raise rates in the current tightening cycle. The Bloomberg report provides confirmation that recent comments from BoJ officials including Governor Ueda were intended to signal to market participants that rates would be raised this month, and that the government will not stand in their way. The report did note though that the final decision over a rate hike will be made at the last minute after assessing all economic data and information. The latest Tankan survey is scheduled to be released ahead of the next BoJ policy meeting on 14th December, and unless there is a significant downside surprise to business confidence we expect the BoJ to hike rates by 25bps this month. We then expect the BoJ to stick to a gradual pace of tightening, forecasting two rates hikes (every six months) next year lifting the policy rate up to 1.25% by the end of 2026.

The Bloomberg report overnight has encouraged the Japanese rate market to almost fully price in a BoJ rate hike this month lifting short-term yields in Japan. The 2-year JGB yield has risen by a further 3bps overnight bringing the cumulative increase for this week to 7bps. The sharp move higher in short-term yields has reinforced the sell-off at the long-end of the JGB curve that had been triggered over the past month by concerns over looser fiscal policy in Japan including the government’s bigger extra budget. There has been some divergence in performance between the long and super long-end of the JGB curve. The 10-year JGB yield has jumped by around 14bps this week while the 30-year yield is up by only around 2bps. The 30-year JGB yield has been adjusting lower at the end of this week after yesterday 30-JGB auction revealed the strongest bid-to-cover ratio since 2019 indicating higher yields are becoming more attractive for investors. When asked about recent moves in JGB yields overnight at a news conference, Finance Minister Katayama stated they continue to monitor developments closely and make sure market trust isn’t lost. She emphasized that “we are, of course, giving due consideration to fiscal sustainability in the budget drafting” for the next fiscal year. The comments tentatively indicate that continued upward pressure on government borrowing costs could curtail the government’s plans for looser fiscal policy. A development that would help to ease downside risks for the yen next year alongside continued BoJ policy tightening.

SHIFTING SLOPE OF JGB CURVE

Source: Bloomberg, Macrobond & MUFG GMR

EUR: Will political risks in Europe derail outlook for stronger euro?

Like the yen, the euro is on track for its second consecutive week of gains against the US dollar. It has helped to lift EUR/USD back up closer to the 1.1700-level as the US dollar has weakened broadly ahead of next week’s FOMC meeting. The euro is benefitting from market expectations that the policy divergence between the Fed and ECB will continue narrow going forward as the Fed keeps lowering rates back to neutral while the ECB has already arrived there, and is more likely to leave rates on hold now. Political risks in the euro-zone mainly in France have dampened the euro’s upward momentum in recent months. The French government still has to pass a budget for next year which has the potential to trigger a renewed flare up in political risk before year end, although we assume they will carry over the current budget and try again early next year if parliament fails to pass next year’s budget in time.

Bloomberg is also reporting that political risks in Germany may attract some market attention today. The ruling coalition government’s pension bill will be voted on today with the final ballot in the Bundestag scheduled for around 12.30pm local time and result expected to be announced at around 1pm. It has been reported that there is a risk the bill could be rejected. Bloomberg has reported that a group of about 18 younger lawmakers from Chancellor Merz’s own party have rebelled against the pension bill although it is unclear how many of them might reject the law. The ruling coalition only has a slim majority of 12 seats highlighting the risk of an embarrassing defeat for the coalition government, and potentially undermining Chancellor Merz’s credibility and the stability of the coalition. However, the government could be helped by the Left party that plans to abstain in the vote reducing the number of votes required to pass the bill to 284 which should be easier for the coalition to meet given they hold 328 seats. While we remain wary of political risks in Europe, we do not expect them to derail our outlook for the euro to strengthen further against the US dollar over the next 6-12 months.

JPY: Relationship between USD/JPY and yield spreads has broken down

The recent relationship between USD/JPY and US-JP yield spreads confirms a structural shift in USD/JPY dynamics. Historically, the pair has closely tracked short-term US-JP rate differentials, making the 2-year spread a core input in our short-term fair value model alongside implied volatility, risk reversals, and other macro features. However, since October, our regression models have shown a persistent mis-valuation between spot and the fair value. This divergence coincides with a sharp drop in correlation between USD/JPY returns and US-JP yield spreads: prior to October 2025, the 12-week rolling correlation with the 10-year spread averaged +0.43, peaking at 0.91 in February, whereas post-October 2025 the average correlation collapsed to -0.07 with eight consecutive negative weeks through to the present. We interpret this as USD/JPY price action reflecting Japan-centric risk factors rather than US rate dynamics. This shift is driven by fiscal uncertainty triggered by Sanae Takaichi becoming prime minister and the bigger extra budget. Consequently, the upcoming policy decisions from the BoJ and Fed may exert less directional pull on USD/JPY than in prior regimes. If fiscal concerns persist the yen could remain weak even as yield spreads continue to narrow.

JPY WEAKNESS OVDERSHOOTING NORMAL SHORT-TERM DRIVERS

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com