The yen weakened to 163.99 per dollar, its lowest point since November 1986. The yield on Japan's 40-year bond climbed to 4.01%, nearing the all-time high of 4.355% reached in May. Meanwhile, the Bank of Japan's benchmark rate sits at 1% after a hike last month - the highest in 31 years.
Japan's economy has long battled deflation, and the BOJ's ultra-loose policy was designed to stimulate growth. However, the recent plunge in the yen has fueled imported inflation, forcing the central bank to reconsider its stance. The rise in the 40-year bond yield reflects market expectations that further rate hikes are on the horizon.
A depreciating currency increases the cost of imported goods, directly stoking inflation. The yen's weakness is driven by jitters over Japan's fiscal situation, rising oil costs, and the growing rate differential with the US. The prolonged yen weakness has significant repercussions for Japan's economy, raising the cost of imported goods and squeezing household budgets.
Higher energy prices amplify these pressures, as Japan relies heavily on imported fuel. The BOJ faces a delicate balancing act between supporting growth and curbing inflation. With the yen at multi-decade lows, the risk of intervention by Japanese authorities increases, though such moves have historically had limited lasting impact.
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This yen slide also puts additional strain on Japanese exporters, who benefit from a weaker currency in the short term but face higher input costs for raw materials. Importers, meanwhile, see margins squeezed as they absorb rising expenses that are difficult to pass on to consumers in a sluggish domestic economy. The BOJ's previous rate hike in June was already a milestone, yet the currency's continued depreciation suggests markets expect further tightening is needed to stem the slide and anchor inflation expectations.
"Higher energy prices, a weak yen, and the faster pass-through of these costs to consumers are increasingly concerning BOJ officials," said Stephen Spratt and Reo Sakida, strategists at Societe Generale.
Dayeon Hong, Asia Pacific strategist at Natixis, said: "With dollar-yen currently well above 163, there is a chance that the BOJ will adopt a significantly more hawkish tone at its July 31 meeting." She said that following this month, traders might begin to anticipate a more rapid pace of rate increases.
Barclays economists Naohiko Baba and Takashi Onoda believe BOJ Governor Kazuo Ueda will "take every effort to strike a hawkish tone" at the meeting, especially concerning when the next rate increase might occur, aiming to curb the yen's slide and buy breathing room before the next hike.
Strategists at Societe Generale advise selling five-year Japanese government bonds while buying 30-year bonds, a trade that gains if the yield curve experiences a bear flattening. Hong at Natixis recommends a two-year yen interest-rate payer swap, which benefits when short-term rates increase. Barclays forecasts the BOJ will raise rates next in October, followed by another increase in April.
A Bloomberg survey shows that 50% of economists polled still anticipate the BOJ will hold off until December to raise rates. In contrast, Barclays economists predict rate rises in October and April. Swap markets imply roughly 32 basis points of BOJ tightening by year-end.
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