BOJ EXIT Pathway.
a BASE-RATE MODEL OF POLICY NORMALIZATION

The Bank of Japan's policy normalisation has been the most significant central bank story of the 2024 to 2026 period that the Western financial press has consistently undervalued. The BoJ ended its yield curve control (YCC) framework in March 2024 and has since raised the policy rate from -0.10 percent to 0.50 percent as of early 2026. By historical standards, that is a very modest tightening. In the context of 25 years of zero and negative interest rate policy, it is a structural shift of considerable importance.

The exit is not a normalisation in the conventional sense because Japan's starting conditions are unlike any other major economy. Government debt-to-GDP of approximately 260 percent. A central bank balance sheet representing over 120 percent of GDP. A bond market where the BoJ has been purchasing virtually all net new JGB issuance for years. An exchange rate that declined from 110 per dollar in 2021 to 160 per dollar by mid-2024 before partially recovering.

The exit must therefore be managed as a controlled corridor rather than executed as a clean policy change. Moving too fast risks destabilising the JGB market, triggering a fiscal funding crisis and creating yen carry trade unwind events that reverberate across global asset markets. Moving too slowly risks further yen depreciation, inflation persistence above the 2 percent target and political backlash from households facing import price increases.

The BoJ articulated three preconditions for continued rate increases after the July 2024 hike: sustained wage growth above 3 percent, services CPI consistently above 2 percent, and yen stability sufficient to avoid importing additional inflation.

The Shunto wage negotiations, Japan's annual spring wage round, delivered average wage increases of 5.28 percent in 2024, the largest in three decades, and approximately 4.6 percent in 2025. Both prints were above the BoJ's 3 percent threshold and provided the cover for the January 2025 hike to 0.25 percent and the subsequent hike to 0.50 percent in January 2026.

Services CPI has been less consistently above 2 percent. It has oscillated between 2.1 and 2.9 percent through 2025, with accommodation and restaurant services leading and durables services lagging. The BoJ's internal models suggest services inflation needs to be sustainably above 2.5 percent before it can be confident that the transition from imported goods inflation to domestic demand inflation is structurally complete.

The JGB market is the existential risk in the BoJ normalisation story. The BoJ holds approximately 54 percent of outstanding JGBs. As it begins reducing purchases, the question is whether private domestic and foreign investors will absorb JGB supply at yields that are consistent with Japan's fiscal sustainability.

Japan's fiscal breakeven rate (the JGB yield at which debt service costs consume an unsustainable share of government revenue) is estimated by most models at approximately 2.0 to 2.5 percent on the 10-year. The BoJ is currently allowing the 10-year JGB to trade between 0.5 and 1.5 percent with flexible intervention above that range.

The terminal rate path consistent with achieving the 2 percent inflation target without destabilising JGB markets is the central modelling challenge. Most BoJ watchers place the terminal rate at 1.0 to 1.5 percent by 2028. That terminal implies 10-year JGBs at 1.5 to 2.0 percent, which is manageable but requires a gradual and signalled exit to avoid market dislocation.

The yen depreciated from approximately 110 per dollar in early 2022 to a trough of 161 in July 2024, a depreciation of approximately 46 percent. The primary driver was the interest rate differential: the Fed was hiking aggressively while the BoJ held rates near zero and defended its YCC ceiling.

The partial recovery to approximately 145 to 150 per dollar in early 2026 reflects the narrowing of the differential as the BoJ has begun normalising and the Fed has begun cutting. The desk's base case is that USDJPY trades in the 140 to 148 range through 2026, reflecting a gradual narrowing of the rate differential without a sharp carry trade unwind.

The risk scenario is a rapid carry unwind. Global risk-off episodes tend to trigger yen appreciation because of Japan's large net creditor position: Japanese investors repatriate overseas investments in stress, creating yen demand. The July 2024 carry unwind, which sent USDJPY from 161 to 143 in a matter of days, demonstrated the non-linearity of this dynamic.

Japanese equities have outperformed in the 2024 to 2026 normalisation period for a counterintuitive reason: rate rises in Japan have been interpreted as evidence that the economy is finally generating sustainable domestic demand growth, which is positive for corporate earnings. The Nikkei's performance has also been partially driven by corporate governance reforms that are unlocking shareholder value in previously capital-inert balance sheets.

For foreign investors, the equity return must be evaluated in hedged versus unhedged terms. The yen carry cost for USD investors hedging JPY equity exposure is approximately 4.5 to 5.0 percent (the USD-JPY interest rate differential), which is material relative to the equity return. Unhedged exposure creates a complex view on USDJPY.

For JGBs: the normalisation corridor is unfriendly to long-duration JGBs. The desk avoids duration beyond the 5-year point in JGBs and prefers inflation-linked JGBs (JGBi) as a better risk-adjusted vehicle for Japan fixed income exposure.