Merchant: Japan's resumption of rate hikes may create pressure on global financial conditions.

China Merchants Bank released a research report stating that on December 19th, the Bank of Japan raised interest rates by 25 basis points, increasing the policy rate to 0.75%, in line with market expectations. All 9 members of the committee voted in favor of the rate hike decision. This brings the policy rate to its highest level since 1995. This is the Bank of Japan's second rate hike since January 2025, with 11 months passing between the two rate hikes. The rate hike by the Bank of Japan was as expected, and the market reaction was subdued. Japanese stocks continued to rise, the yield on 10-year Japanese government bonds fluctuated higher, and the yen depreciated to around 156 after the rate hike, with other market reactions remaining subdued. The main points from China Merchants Bank are as follows: Policy: Gradual Rate Hikes The Bank of Japan chose to raise interest rates under dual pressures of high inflation and yen depreciation. In terms of inflation, Japan's CPI inflation reached 3.0% in November, with policy rates significantly lagging behind the inflation curve and real interest rates in deep negative territory. Regarding the exchange rate, the US dollar broke above 156 yen, prompting the Bank of Japan to take measures to curb the downward trend. The Bank of Japan may not choose to rapidly catch up with the inflation curve, and gradual rate hikes are still the baseline scenario, with future rate hikes potentially remaining at 2 times per year, each time by 25 basis points, raising the policy rate to the range of 1-1.5% by 2026. Looking at the inflation structure, the high inflation pressure mostly comes from the supply side and is not sensitive to rate hikes. Food and utilities are items that are driving inflation, while the repair of service inflation is more related to the "labor shortage" caused by aging population. In terms of economic performance, Japan's economy contracted in the third quarter, with the trade war creating a severe impact on investment and exports. In terms of fiscal security, the combination of "high inflation, low interest rates" allows Japan's economy to have high nominal growth and low nominal interest rates simultaneously, with economic expansion speed higher than the rate of debt expansion, leading to the convergence of government leverage ratio. From 2020 to 2025, this model is expected to bring Japan's government leverage ratio down by 16 percentage points to 215%, with further declines possible in the next five years to 200%. Strategy: Beware of Risks Although the Bank of Japan is likely to maintain a highly restrained pace of rate hikes, yen liquidity reversals and the Japanese bond market will continue to suppress global financial conditions. Firstly, there may be a sustained reversal in yen carry trades, which could have a long-term suppressing effect on global asset liquidity. As of the end of 2024, there were still around $9 trillion in positions with yen as a source of liquidity, and this part of liquidity may gradually shrink as the spread between US and Japanese interest rates narrows. However, the current net short position on the yen has significantly converged, reducing the probability of a repeat of the global market turmoil caused by the "yen reversal" in July 2024. Non-commercial speculative positions have turned to yen long, presenting a stark contrast to the approximately 180,000 net short positions on the yen in July 2024. Although hedge funds are still short on the yen, their positions are only at 56% of the levels seen in July 2024, meaning that any reversal in yen carry trades may have a relatively mild impact on the market. Secondly, Japanese bond risks may further escalate. In the short term, the Japanese government has approved a supplemental fiscal budget equivalent to 2.8% of nominal GDP. In the long term, Japan plans to increase defense spending to 3% of nominal GDP, as well as permanently exempting the consumption tax. Japan's untimely fiscal expansion stance may cause greater market concerns, leading to a steep rise in long-term Japanese bond yields, accelerating the steepening of the yield curve. The upward movement in long-term rates will significantly constrain Japan's economy, compounded by the impact of the trade war, persistent supply-side inflation pressures, leading to a potential scenario of "stagflation," which could accelerate the deterioration of fiscal sustainability conditions. Japanese bonds and the yen face medium to long-term pressures, with Japanese stocks showing relative preference. Regarding Japanese bonds, rate hikes will directly push up Japanese bond yields, especially at the long end where high debt levels and high inflation create a vicious cycle of upward pressure. While rate hikes may lead to a period of yen appreciation, considering the Bank of Japan's cautious attitude towards rate hikes, coupled with market concerns about Japanese debt, the yen is likely to lack strong upward momentum and continue to trend weakly. As for Japanese stocks, the liquidity impact of rate hikes may be more short-term. Given that Japanese companies are mostly operating globally, combined with the continued trend of global AI and computing power investments, Japanese stocks are expected to continue in a trend of strong oscillation.