ROI-Yen struggles to exit 'danger zone' even as Japan hikes rates: McGeever

By Jamie McGeever

ORLANDO, Florida, Dec 18 (Reuters) - The Japanese yen was the worst-performing major currency against the bruised U.S. dollar in 2025, even though the Bank of Japan was the only major central bank to raise interest rates. Further tightening will not guarantee the yen escapes the intervention "danger zone."

The BOJ is expected to continue its gradual tightening cycle on Friday with a quarter percentage point rate increase, bringing its policy rate to ?a three-decade-high of 0.75%. Interest-rate futures imply around 40 basis points of additional hikes next year.

As things stand, that will make the BOJ one of the most hawkish G10 central banks next year along with the ?Reserve Bank of New Zealand and the Reserve Bank of Australia. Governor Kazuo Ueda's guidance on Friday will be closely scrutinized for clues about the BOJ's appetite ?for additional tightening.

But more hikes are no guarantee that the yen will recover in 2026. Most major central banks ?are close to the end of ?their easing cycles, with the notable exception of the Federal Reserve. If monetary policy starts tightening globally in the coming year, other central banks could quickly narrow the gap with the BOJ.

ATTRACTIVE YIELDS, SHAKY MARKET

Ueda has ?to perform a delicate balancing act, with pressure coming from three different fronts: Prime ?Minister Sanae Takaichi, bond investors, and the currency market. With so little room to manoeuvre, he will likely maintain the cautious stance he has taken this year.

Japan's economy appears to be rebounding from a U.S. tariff-fueled contraction in the third quarter. Big business sentiment is the ?highest in four years, the labor market is the tightest in decades, by ?some measures, which should ?support wage growth and consumer spending.

Moreover, inflation is entering its third year above the BOJ's 2% target, so the natural urge among BOJ officials may be to raise rates faster.

But the Japanese government bond (JGB) market - burdened by public debt of around 250% of GDP, the world's highest - ?is not so ready and willing.

To be sure, higher JGB yields will attract foreign demand, especially private sector pension funds and central bank reserve managers seeking to diversify away from their dollar-denominated holdings.

Ministry of finance data shows that foreigners currently hold 12.2% of all JGBs and Japanese bills. That's more than double the share held in 2010 and close to the record high of 14.4% in March 2022.

That share may rise further in 2026. As Jordan Rochester at Mizuho notes, the fragility of the JGB market is forcing domestic life insurance companies to sell, with foreigners eager to buy due to the attractive hedging-adjusted yields.

But the JGB market is fragile ?for overseas investors ?too. It has been the worst-performing major bond market in the world this year, with the 10-year JGB yield now at its loftiest point since 2007 and longer-dated yields hovering near record highs.

YEN'S INTERVENTION ZONE

Bond yield spreads have moved significantly in the yen's favor this year, yet ?the currency has still struggled, hitting a record low against the euro and slumping back toward the 160 per dollar level that triggered government yen-buying in recent years.

Ministry of finance officials have issued intervention warnings in the past month, but there appears to be little appetite to act, at least as long as dollar/yen stays below 160.00. At this point, the only thing keeping those wolves at bay seems to be the latest bout of dollar weakness.

The main reason the yen and JGB market are under so much pressure is, of course, Japan's fiscal plight. The upper house on Tuesday passed an 18.3 trillion yen ($118 billion) supplementary budget, the country's largest stimulus package since the pandemic. Takaichi's spending splurge will mostly be financed through ?new debt issuance.

The BOJ governor will be careful not to rock the bond market on Friday. But no matter what he does, JGBs and the yen are entering the new year on shaky ground.

(The opinions expressed here are those of the author, a columnist for Reuters)

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(By Jamie McGeever; Editing by Marguerita Choy)