Will the Bank of Japan continue to "hold steady" this week? With improved trade conditions, when to raise interest rates becomes the biggest highlight

The Bank of Japan is likely to maintain interest rates unchanged on Thursday. Against the backdrop of improved uncertainty in the US-Japan trade, market expectations for interest rate hikes are heating up, with October becoming a popular time for the next rate increase.

A Bloomberg survey shows that the 56 economists surveyed unanimously expect the Bank of Japan to keep the interest rate at 0.5% during this week's monetary policy meeting. Economists anticipate that the central bank may raise its inflation forecast for the current fiscal year in its quarterly economic outlook report.

The main focus of this meeting is when the Bank of Japan will raise interest rates again. Insiders previously indicated that Bank of Japan officials believe that after the US-Japan trade agreement has eliminated key uncertainties, a rate hike can be considered.

Market pricing shows that traders currently expect an approximately 80% chance of a rate hike before the end of the year, with October becoming an increasingly popular potential time for the next rate increase.

Significant Reduction in US-Japan Trade Agreement Uncertainty

The US-Japan trade agreement is a key variable for this central bank meeting.

According to CCTV News, the US and Japan previously reached an agreement on tariff issues. Under the agreement, the US will impose a uniform 15% tariff on Japanese goods, including automobiles, down from the previous 25% rate applicable to global automobile imports. In exchange, Japan has committed to establish a fund of up to $550 billion for direct investment in the US.

The agreement sets most tariffs on Japan at 15%, especially reducing the automobile tariff from the 25% imposed by Trump in April to 15%, providing significant relief for Japan's core economic sector.

After the US-Japan tariff agreement was reached, market expectations for a rate hike by the Bank of Japan rebounded significantly.

Nomura statistics show that as of the morning of July 28, the overnight index swap (OIS) market expected the probability of a 25 basis point rate hike at the October monetary policy meeting (MPM) to be about 65%, with an 80% probability for the December monetary policy meeting and nearly 100% for the January 2026 monetary policy meeting.

However, Goldman Sachs believes that although uncertainty has eased, considering that the US and Japan are still negotiating details, the central bank will continue to take a wait-and-see approach as a precaution. Bank of America stated that the market's pricing of a 65% chance of a rate hike at the October meeting may be excessive, and recent expectations for a rate hike face the risk of adjustment.

The Bank of Japan has also expressed a similar cautious stance recently. Officials believe that the negotiation results are roughly within expectations, and the central bank may not need to make significant changes to the overall economic outlook. Bank of Japan Deputy Governor and key policymaker Masayoshi Amamiya stated last week that although the US-Japan agreement is a significant breakthrough, uncertainty remains high.

Bank of America believes that after this week's monetary policy meeting, Bank of Japan Governor Kazuo Ueda may release a "relatively hawkish" signal, indicating that his remarks will be "less accommodative" than in June—simply put, he will not emphasize "continuing to stimulate" as before, and the attitude will lean more towards "the situation is improving."

October Becomes a New Popular Rate Hike Timing

The market has fully priced in a rate hike in January next year. October is becoming an increasingly popular potential timing for the next rate hike. Investment banks, including Deutsche Bank and Barclays, have brought forward their expectations for the next rate hike to October this year.

However, Goldman Sachs believes that given that core inflation and long-term inflation expectations have not yet reached 2%, and there are no signs of financial imbalances, the central bank does not have an urgent need to raise rates. The central bank may wait to confirm the wage growth momentum in spring next year before taking action. A rate hike in January next year remains the baseline scenario.

Nomura stated that, considering that the trade agreements between the US and Japan and between Europe and the US have achieved a relatively low tariff rate of 15%, and that Trump's overall stance on tariffs has softened, the possibility of resuming rate hikes within this year or fiscal year has indeed increased. However, the market has fully priced in the January rate hike, leaving limited room for further increases.

Even if a rate hike occurs, the space for the Bank of Japan to act is relatively limited.

Despite a significant rise in market expectations for short-term rate hikes, the expected increase in terminal rates is relatively moderate. The "two-year forward one-year rate (2y1y)", typically viewed as a substitute variable for terminal rate expectations, has only risen to slightly above 1.0%.

Nomura explained that although the tariff rate has fallen from its peak, it has risen to 15% compared to nearly zero levels last year. This is likely to have a negative impact on medium- to long-term economic growth in Japan and globally, and exert downward pressure on neutral rates.

Inflation Outlook: Partial Upward Adjustment but Overall Framework Remains Unchanged

Regarding inflation, it is expected that the Bank of Japan will raise its short-term inflation forecast driven by food prices.

This year's spring labor negotiations saw a basic wage increase of 3.7%, surpassing last year's 3.6%. During the traditional price adjustment period in April, food price increases exceeded the central bank's expectations, particularly for staple foods like rice.

As a result, the Bank of Japan is expected to raise its core CPI forecast for fiscal year 2025 from 2.2% to about 2.5%.

The medium-term inflation path may remain unchanged.

Bank of America expects that despite the upward adjustment in short-term forecasts, the central bank still anticipates that the inflation rate will slow to below 2% in fiscal year 2026, before reaching the 2% target again in the second half of fiscal year 2026. The core CPI and new core CPI forecasts for fiscal year 2027 are expected to remain around 2%.

The central bank's risk assessment of the economic and price outlook may be adjusted from "significant downside risks" to "upward and downward risks are basically balanced," reflecting the positive impacts of trade agreements and recent inflation developments.

Bond Market: Political Premium Gradually Eases

Currently, political uncertainty in Japan is pushing up long-term yields.

Questions regarding whether Shigeru Ishiba will resign, who will succeed as the president of the Liberal Democratic Party and Prime Minister, and whether the opposition parties will join the coalition remain unclear, increasing the difficulty of forecasting fiscal policy. These factors are pushing up long-term Japanese government bond yields through fiscal and uncertainty premiums, steepening the yield curve However, this premium is expected to gradually decline. Nomura expects that whether Shigeru Ishiba will resign may become clear in August, with a successor to be determined in the fall, and it will be clarified by the end of the year whether the opposition will join the coalition and whether to cut the consumption tax.

As political and fiscal policy uncertainties gradually ease, the fiscal and uncertainty premiums in Japanese government bond yields will also decline.

The 10-year Japanese government bond remains attractive. Even if the market expects the central bank's policy rate to rise to 1.0% and fully prices in a rate hike to 1.25%, if the aforementioned premiums decline, the holding yield and rolling yield will still exceed capital losses. The current holding yield of the 10-year Japanese government bond is approximately 11 basis points, and the rolling yield is about 10 basis points.

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