The likelihood of Japan's 🇯🇵 Bank of Japan significantly raising interest rates is increasing noticeably, yet hardly anyone seems to notice.

Currently, observers of the Bank of Japan estimate about a 37% chance of a rate hike by April, up from only 15% in January. Markets are also pricing in approximately 25 basis points of increases by July, with a 90% probability of a second hike before December. Governor Kazuo Ueda is expected to keep rates unchanged on Thursday but may hint that the path toward monetary policy normalization is still underway.

Japan is the largest foreign holder of U.S. Treasury bonds. When the Bank of Japan raises rates, Japanese government bonds become more attractive relative to U.S. debt. This causes capital to flow back into Japan, exerting selling pressure on U.S. Treasury bonds precisely when the United States needs more buyers than ever to finance a deficit exceeding $2 trillion.

The last time the Bank of Japan surprised markets with a rate hike was in July 2024, during a sharp sell-off in global markets. That was when the unwinding of the so-called yen carry trade began, where investors borrow cheap yen to buy higher-yielding assets. Trillions of dollars in leveraged positions are based on the assumption that Japanese interest rates will remain near zero.

Adding to this is an oil price shock. Japan imports nearly all of its crude oil from the Middle East. With Brent crude rising to around $106, inflationary pressures are mounting, providing the Bank of Japan with another reason to raise rates—while at the same time threatening the growth that Japan’s economy needs. This situation places policymakers in what resembles a policy trap.

If the Bank of Japan continues to normalize its monetary policy while the U.S. Federal Reserve remains constrained by its circumstances, a divergence in policies could develop that destabilizes global capital flows.

Therefore, it is crucial to monitor Japan closely this week...