BOJ & BOE Rate Gap Narrows

On Wednesday, 31 July, the Bank of Japan (BOJ) raised its short-term policy rate to 0.25% for the first time since 2008, defying the dominant market expectation that the bank would keep rates unchanged. The BOJ also decided to halve its monthly bond buying to 3 trillion yen by 2026, further unwinding its longstanding, easy monetary policy. 

After the announcement, the Japanese yen rallied 0.8% against the greenback (USD/JPY) while sending the British pound (GBP/JPY) to its lowest level since 16 May due to narrowing central bank policies. The BOJ's interest rate hike is largely contrasting with that of other major central banks. 

The European Central Bank (ECB) proceeded to cut its interest rates, and the Federal Reserve, which reports its decision later today, Wednesday, 31 July, is projected to follow suit in September. 

Some argue that the Bank of England (BOE) should also cut interest rates during its meeting on 1 August, Thursday, to avoid falling behind significant economies. The Bank's decision may also be impacted by what the Federal Open Market Committee (FOMC) announces today. Let’s take a closer look:

The BOJ’s Rate Hiking Rationale

The BOJ's decision to raise interest rates from 0-0.1% prior came due to widening wage hikes and rising services prices as firms passed higher labour costs onto services prices. The Bank also highlighted that import prices were accelerating despite recent moderation and warned that inflation might be more influenced by yen movements today than in the past.

Despite hiking its benchmark rates, the BOJ maintained its inflation forecast at the 2% target through fiscal 2026. The Bank said that if the economy and prices develop in line with its latest projections, it will adjust monetary policy as needed. This is especially relevant as BOJ also emphasised that real interest rates, adjusted for inflation, remain in negative territory.

For context, the BOJ ended its negative interest rate policy (NIRP) in March 2024, a major shift away from a multiyear ultra-loose policy. Some economists and policymakers argued that low rates weakened the yen and raised the cost of imported goods. This was seen as detrimental to the Japanese economy, which experienced a drop in its Gross Domestic Product (GDP) in Q1 2024.

The BOJ's decision appears to have considered global trends, particularly the Fed's expected rate cuts in September. By narrowing the interest rate differential between Japan and the US, the Bank aimed to stabilise its currency and better manage global investment flows.

Yields on 10-year Japanese government bonds fell following the announcement, and banking stocks rose due to the expectation that higher rates would improve lending margins.

Expectations for BOE

As far as the BOE goes, more than 80% of economists polled by Reuters forecast a 25 basis point cut. However, traders in swaps markets are not as convinced, pricing an even split of 50%- 50%.

While the UK economy is indeed experiencing growth after a soft recession last year, the Bank faces concerns similar to those of the BOJ: high inflation and wage growth pressures. As a result, it appears reluctant to cut rates until there is more evidence that inflation can remain low. 

However, the Monetary Policy Committee (MPC) also hinted in June that they would consider all available information to assess falling inflation, which suggests they concluded that inflation risks are diminishing and creating some leeway for a rate cut. 

On the one hand, some economists, like Allan Monks of JPMorgan (JPM), argue that although a rate cut is likely, the votes might be too tight (e.g., a 5-4 vote). On the other hand, others debate that sticky services inflation could prevent the BOE from cutting as it reflects underlying inflationary pressures within the UK's domestic economy. On that note, the ECB went ahead with an interest rate cut despite persisting services inflation. (Source: Yahoo Finance)

GBP/JPY Reaction and Outlook 

The BOJ's decision to hike has narrowed the interest rate gap between Japan and the UK, favouring the Japanese yen. The GBP/JPY cross-pair continued posting losses after the surprise decision and could struggle further due to expectations of a BOE cut on Thursday, 1 August. A rate cut would narrow the gap more and may weigh on the British pound. 

GBP/JPY remains in bullish territory above the 200-day moving average (MA), with pullbacks expected to find support at the critical support currently seen near 191.50. On the flip side, breaking past the 200 yen resistance, the pair could test the 50-day MA at around 201.50.

Conclusion

The BOJ's unexpected rate hike and reduction in bond-buying have strengthened the yen and put pressure on the British pound as the interest rate gap between the two Banks has narrowed. With most economists expecting the BOE to cut rates by 25 basis points in the upcoming meeting on 1 August, the GBP/JPY pair could post additional losses as a rate reduction by the UK's central bank would narrow the gap further. However, uncertainty remains around the BOE's move, particularly regarding sticky services inflation and the potential influence of the Fed's decisions on Wednesday.

Technical analysis suggests that GBP/JPY remains bullish above the 200-day MA, with key support near 191.50 and resistance around 200 yen. However, a rate cut could further weigh the British pound, potentially leading to more GBP/JPY volatility.

Investors may be keen to monitor the outcomes of the Fed and BOE meetings, as these will likely significantly impact the GBP/JPY and other pairs and continue to shape the forex market in the coming months.