CMB: Japan restarts interest rate hikes or suppresses global financial conditions

The Zhitong Finance App learned that China Merchants Bank released a research report saying that on December 19, the Bank of Japan raised interest rates by 25 bps and raised the policy interest rate to 0.75%, in line with market expectations. Nine members of the committee fully supported the interest rate hike decision. At this point, the policy interest rate hit the highest level since 1995. This is another rate hike by the Bank of Japan after a lapse of 11 months after the interest rate hike in January 2025. The Bank of Japan raised interest rates in line with expectations, and the market reaction was lackluster. Japanese stocks continued to rise, and the 10Y interest rate on Japanese bonds fluctuated higher. The yen depreciated to around 156 after the interest rate hike was implemented, and the rest of the market reaction was lackluster.

China Merchants Bank's main views are as follows:

Policy: Slowly raise interest rates

The Bank of Japan chose to raise interest rates under the double pressure of high inflation and depreciation of the yen. In terms of inflation, Japan's CPI inflation reached 3.0% in November. Policy interest rates fell far behind the inflation curve, and real interest rates were in a deeply negative range. In terms of exchange rates, the US dollar once broke through the 156 mark against the yen, and the Bank of Japan needed to take measures to curb the unilateral downward trend.

The Bank of Japan will probably not choose to quickly catch up with the inflation curve. The slow rate hike is still the benchmark situation. In the future, the slope of interest rate hikes may be maintained 2 times per year, 25 bps each time, and the policy interest rate will be raised to the 1-1.5% range in 2026. Judging from the inflationary structure, the high inflationary pressure comes more from the supply side and is not sensitive to interest rate hikes. Food, water, electricity, and gas are marginal increases in inflation, and the repair of service inflation also comes more from the “labor shortage” caused by aging. Judging from economic performance, the Japanese economy contracted in the third quarter, and the trade war had a severe impact on investment and exports. From the perspective of financial security, the combination of “high inflation and low interest rates” allows the Japanese economy to have both high nominal growth and low nominal interest rates. The rate of economic expansion is corresponsively higher than the rate of debt expansion, and the government's leverage ratio tends to converge. In 2020-2025, this model reduced the Japanese government's leverage ratio by 16pct to 215%, and is expected to fall further to 200% in the next five years.

Strategy: Be aware of risks

Although the Bank of Japan is likely to maintain a high degree of restraint in the pace of interest rate hikes, the reversal of yen liquidity and the Japanese bond market will still suppress global financial conditions.

First, yen arbitrage transactions may continue to reverse, putting long-term pressure on global asset liquidity. As of the end of 2024, there are still about $9 trillion of positions using low-interest yen as the source of liquidity. In the future, this portion of liquidity may shrink steadily as interest spreads between the US and Japan narrow. However, the current net short position of the yen has settled significantly, and it is unlikely that the “yen reversal” in July 2024 will cause a sharp shock in the global market. Among them, non-commercial speculation has turned into a long yen position, in stark contrast to the 180,000 yen net short position in July 2024. Although leveraged funds are still short in yen, their position size is only 56% of the July 2024 level, which means that the impact of the reversal of yen arbitrage trading on the market may be relatively mild.

Second, the risk of Japanese debt is likely to grow further. In the short term, the Takaichi Sanae government approved a supplementary budget equivalent to 2.8% of nominal GDP. In the long run, Japan plans to raise defense spending to 3% of nominal GDP, and permanently reduce consumption tax. The Japanese government's untimely fiscal expansion stance may raise even greater concerns in the market. The yield on medium- to long-term Japanese bonds may rise steeply, and the curve is steeper at an accelerated pace. The rise in long-term interest rates will have a significant restrictive effect on the Japanese economy. Combined with the impact of the trade war, supply-side inflation will remain high, and the macroeconomic environment may fall into “stagflation,” and fiscal sustainability conditions may deteriorate at an accelerated pace.

Japanese bonds and yen are facing medium- to long-term pressure, and the performance of Japanese stocks may be relatively favorable. On the Japanese bond side, interest rate hikes will directly drive interest rates on Japanese bonds upward. In particular, ultra-long-term interest rates are still facing a vicious cycle of high debt and high inflation, and upward pressure continues. On the yen side, although interest rate hikes are expected to drive a phased appreciation of the yen, considering that the Bank of Japan's attitude of raising interest rates is still moderate, compounded by market concerns about Japanese debt, the yen is expected to lack momentum to strengthen unilaterally, and it is likely that the weak and volatile trend will continue. On the Japanese stock side, the liquidity shock brought about by interest rate hikes is more short-term. Considering that most Japanese companies operate globally, compounded by the continued fermentation of the global AI and computing power investment boom, Japanese stocks are expected to continue to fluctuate and strengthen.