The Bank of Japan raised interest rates as scheduled, increasing concerns about "arbitrage trading" position liquidation

With the Bank of Japan raising interest rates by 25 basis points as expected, concerns about the unwinding of arbitrage trades are intensifying. Earlier today, yen options traders inferred that the likelihood of a stronger yen in the coming weeks is greater, suggesting that the market has already priced in certain risks.

On January 24th, Friday, the Bank of Japan decided to raise interest rates by 25 basis points to 0.50%, in line with expectations, marking the largest increase in Japan in eighteen years. The Bank of Japan stated in its announcement that, with wages continuing to grow, the inflation rate is gradually moving towards the 2% target.

However, Bloomberg macro strategist Simon White pointed out that Japan, as a "debt-laden" country, faces potential risks in raising interest rates after a long period of rates being close to zero or lower, making a stronger yen more likely.

It is noteworthy that after the Bank of Japan's first interest rate hike at the end of July last year, it triggered turmoil in global financial markets. At that time, the yen strengthened significantly, Japanese and U.S. bond yields fell, and global stock markets faced sell-offs. Although the market eventually recovered, with the S&P 500 index hitting a new high in September, investors remain wary.

Currently, the foreign exchange options market is pricing in a higher probability of a stronger yen. For example, in the case of USD/JPY, the implied probability of a one-touch option with a strike price of 154.4 (below the spot price) is 68%, while the implied probability for a strike price of 158.4 (above the spot price) is 62%.

If the range of spot execution prices is expanded or the expiration time is extended, the tendency for a stronger yen will increase, and this tendency is more pronounced in EUR/JPY. The implied probability of the yen appreciating by 3% against the euro within a month is about 30%, while the probability of depreciating by 3% is only 24%. This also means that the possibility of unwinding arbitrage trades is greater to some extent.

Currently, USD/JPY is quoted at 155.41, down 0.42%.

White also stated that the market reaction to this rate hike may not be as severe as last summer. This is because the yen had already appreciated significantly before last year's rate hike, and traders may be better prepared this time. However, he also warned that:

“The potential risks of the Bank of Japan's interest rate hike cycle still exist, and the bank's balance sheet represents a tail risk that is severely underestimated by global markets.”

The Bank of Japan also mentioned exchange rate issues in its announcement, stating that a weaker yen helps boost inflation expectations. At the same time, the central bank noted that the overall performance of global financial markets is stable, but uncertainties regarding the economy and prices remain high, and real wages will continue to experience significant negative growth