Unlike the past, where economics dictated a strong yen despite loose policy, markets are now driven by politics. The Japanese government is allowing the yen to devalue to manage its debt, even as interest rates rise. This weakens the yen, strengthens the dollar, and could fuel a US equity boom via carry trades.

Despite growing signals of a forthcoming rate hike from the Bank of Japan, analysts caution against an outright bullish stance on the yen. Political uncertainty and a resilient global growth backdrop are significant headwinds. The currency is expected to remain range-bound until key events in early October provide more clarity on both monetary and political fronts.

In 2026, major central banks will diverge significantly. The U.S. Fed and ECB are expected to cut rates in response to slowing growth and disinflation. In stark contrast, the Bank of Japan is poised to hike rates as it finally achieves reflation, making it the sole hawkish outlier among developed market central banks.

The Japanese Yen sold off despite a widely expected rate hike. The market interpreted the Bank of Japan's communication as dovish, reinforcing the view that the BOJ is falling behind the inflation curve, which paradoxically leads to yen selling now.

The upcoming Bank of Japan meeting is the most critical central bank event, with implications beyond FX markets. A hawkish surprise could create a volatility event in Japan's long-end yield curve, which could easily reverberate across global rates markets, impacting carry trades and broader market stability.

Despite Japan breaking its deflationary cycle, the Bank of Japan is hesitant to raise rates. The current inflation is primarily attributed to a weak yen and supply-side factors like energy costs, not robust consumer demand. With real consumption still below pre-COVID levels, the central bank remains cautious.

A surprisingly hawkish BOJ tone, with dissents for a rate hike, bolstered its policy normalization credibility. This stemmed bearish sentiment at the long end of the JGB curve, shifting rate hike pressure to the front end and creating a bias for the curve to flatten.

The Takaichi government has a political incentive to support the Bank of Japan's monetary normalization. Allowing inflation and yen depreciation to continue unchecked could undermine consumer confidence and her high approval ratings. Therefore, a gradual BOJ rate hike could be seen as a politically astute move to maintain stability and popular support.

A significant split in monetary policy is expected in 2026. The US Federal Reserve and European Central Bank are predicted to cut rates in response to slowing growth and easing inflation. In stark contrast, the Bank of Japan is on a hiking cycle, aiming to reflate its economy.