BOJ deputy governor Shinichi Uchida stated that the US-Japan trade agreement represents progress and reduces uncertainty for Japanese businesses. The trade agreement will be incorporated into the next economic outlook report.
Uchida mentioned that uncertainty remains regarding the tariffs’ impact on the economy, with both upside and downside risks present in the outlook. Despite the reduced uncertainty for firms, the need to monitor downside risks persists.
Upcoming BOJ Meeting
The upcoming BOJ meeting may become more interesting, as it will reveal how these developments impact their stance. While a rate change is not anticipated, there is curiosity about whether the BOJ might shift towards a more hawkish position.
We see the remarks from Mr. Uchida as a signal that downside economic risks are easing. With a key trade agreement providing stability, the focus may shift towards Japan’s own economic data. For instance, Japan’s core inflation has remained above the central bank’s 2% target for over two years, recently clocking in at 2.2% in April 2024, giving policymakers a reason to consider tightening.
This opens up opportunities in yen derivatives ahead of the upcoming policy meeting. While the USD/JPY currently trades near multi-decade highs around 157, any hawkish language could trigger a sharp appreciation in the yen. We saw a similar rapid strengthening of the currency in late 2022 when the central bank last surprised markets with a policy tweak.
Monitoring Downside Risks
The emphasis on reduced uncertainty suggests that implied volatility in the yen, which has been elevated, could decline. We believe this makes selling volatility through strategies like short strangles on the USD/JPY attractive. This position would profit if the currency pair stabilizes or if volatility expectations fall after the meeting.
However, we must also heed his caution on monitoring downside risks. If the Bank of Japan ultimately remains fully dovish and disappoints hawkish bets, the yen could weaken further past its current levels. This suggests holding some out-of-the-money USD calls against the JPY could be a prudent hedge against a non-event.
Beyond currency, we are watching Japanese Government Bond futures closely. Any signal of a faster-than-expected policy normalization would likely push yields higher and bond futures prices lower. Traders could position for this by taking short positions in JGB futures.
