The performance of the Japanese yen in August depends entirely on the "mood" of the US stock market?

For investors, the core driving force of the yen interest rate market in August will be the performance of the U.S. stock market.

According to news from the Chasing Wind Trading Desk, Nomura Securities released a research report on the 5th, stating that if the U.S. stock market experiences a deep correction due to economic concerns or the Federal Reserve's policies falling short of expectations, it will directly exert downward pressure on the yen interest rate, potentially triggering a "distortion steepening" of the Japanese government bond yield curve (i.e., a decline in short-term rates and an increase in long-term rates).

The key risk point lies in the Federal Reserve's attitude towards interest rate cuts, particularly Chairman Powell's speech at the Jackson Hole meeting on August 22, as well as the U.S. CPI data released on August 12, both of which could serve as catalysts for a decline in U.S. stocks.

At the same time, internal divisions within the Bank of Japan regarding inflation prospects are becoming apparent. Although Governor Ueda maintains a dovish stance, this adds uncertainty to future policies. In the short term, closely monitoring the U.S. stock market and the Federal Reserve is crucial for trading yen interest rates.

U.S. Stocks Face Correction Risks, Key Variable for Yen Interest Rates

The report points out that the direction of yen interest rates in August will heavily depend on whether the U.S. economy and stock market will experience a more severe correction. The main contradiction in the current market lies in the gap between market expectations for Federal Reserve interest rate cuts and the Fed's own cautious stance.

Although weaker-than-expected non-farm payroll data temporarily strengthened market expectations for earlier and larger interest rate cuts by the Federal Reserve, stabilizing stock prices for a time, the risks have not been eliminated. Federal Reserve Chairman Powell has clearly stated that he is more concerned about the unemployment rate than employment growth. Data shows that the U.S. unemployment rate has remained in a narrow range of 4.0% to 4.2% for over a year, showing no significant signs of increase.

Therefore, Nomura believes that the risk of further declines in U.S. stocks still exists. Two key catalyst points are worth paying close attention to: First, the July CPI data to be released on August 12 (Tuesday); if it exceeds expectations, it will undermine interest rate cut expectations. Second, Powell's keynote speech at the Jackson Hole Economic Symposium on August 22 (Friday); if he shows a cautious stance towards interest rate cuts, it may trigger market sell-offs. Additionally, the so-called "retaliatory tariffs" and actions such as the dismissal of the head of the U.S. Bureau of Labor Statistics are also undermining investor confidence and suppressing market risk appetite.

How Does a Decline in U.S. Stocks Transmit to Yen Interest Rates?

The report clarifies the transmission path between U.S. stocks and yen interest rates. If U.S. stocks further decline in August, the following chain reactions will occur:

1. Market expectations for interest rate hikes by the Bank of Japan will weaken: As risk aversion rises, the market will believe that the Bank of Japan has even less reason to tighten monetary policy in this environment. Currently, the OIS market has lowered the probability of a 25 basis point rate hike in October from an earlier high of 70% to about 37%.
2. Short- to medium-term yen interest rates will face downward pressure: As expectations for rate hikes cool, Japanese government bond yields from the short term to 10 years may further decline.
3. Super long-term government bond yields may rise, leading to "distortion steepening" of the curve: In a typical risk-averse environment, the liquidity of super long-term (e.g., over 20 years) Japanese government bonds will decrease, typically underperforming medium- to short-term bonds, thereby exerting steepening pressure on the entire yield curve This means that yields on maturities of 10 years or more may rise against the trend.

Conversely, if the decline in U.S. stocks proves to be temporary, expectations for the Bank of Japan to take action at its monetary policy meeting in October will resurface, at which point the downward trend in yen interest rates will stop and turn upward.

Divergence within the Bank of Japan is emerging, but the governor's dovish stance is clear

Although external factors are dominant, internal movements within the Bank of Japan are also worth noting. At the recent monetary policy meeting, Governor Kazuo Ueda clearly conveyed a dovish signal of "not in a hurry to raise interest rates." He believes that recent exchange rate fluctuations are largely in line with the central bank's expectations and will not have a significant direct impact on the inflation outlook, and this statement has been interpreted by the market as tacit approval of yen depreciation.

However, a report from Nomura revealed a detail worth paying attention to: there may be divergence within the Bank of Japan's Policy Board. In the latest "Economic Activity and Price Outlook" report, the central bank upgraded the inflation risk from "tilted to the downside" to "roughly balanced risks." Governor Ueda explained at a press conference that this was mainly due to technical adjustments caused by supply-side shocks such as rising food prices, unrelated to the monetary policy stance.

The report's authors believe this explanation is "somewhat illogical." Typically, raising the median inflation forecast would shift the risk balance downward. The simultaneous upward adjustment of both the median and risk balance suggests a general upward shift in inflation expectations among Policy Board members. Governor Ueda's deliberate downplaying of the significance of this adjustment may indicate an increasingly widening divergence in views on the inflation outlook between the executive department, including the governor, and other committee members.

Political factors take a backseat, Nomura raises interest rate hike probability

Regarding other influencing factors, the report suggests that political movements within the Liberal Democratic Party of Japan will not pose a major shock to the market in August, with related impacts not expected to emerge until September at the earliest.

Based on the Bank of Japan's upward revision of the inflation outlook and its risk balance for the fiscal year 2025, Nomura has maintained its main scenario prediction of a 25 basis point rate hike in January 2026, but has raised the probability of its secondary scenario of two rate hikes in October 2025 and April 2026 from the previous 30% to 40%. This reflects that, despite the governor's dovish stance, the hawkish signals revealed in the central bank's report have been sufficient for market institutions to reassess the future rate hike path