Further gains in the yen require a more hawkish stance from the Bank of Japan.

The yen's rally is becoming difficult to sustain, as the market has already priced in a Bank of Japan rate hike this week, while the Federal Reserve's tightening cycle remains slightly ahead of the BOJ through year-end. Further strengthening would require the BOJ to adopt a more hawkish policy path that makes consecutive rate hikes possible, or for the U.S. interest rate advantage to be smaller than investors currently expect. The implied policy divergence is currently challenging the yen's rally. Although the yen rose to its highest level since February, the one-year forward OIS spread between the dollar and yen one year out has rebounded to around 2.5%. This week's policy meeting will test whether this divergence can persist. The OIS market shows about an 85% probability of a 25-basis-point Fed hike on September 16, with a high probability of a cumulative 50 basis points of tightening by year-end. The market has almost fully priced in a BOJ rate hike on September 18, but assigns only a 25% probability to another 25-basis-point hike in October, even though the market expects the BOJ to raise rates by nearly 50 basis points cumulatively by year-end. Therefore, the market expects the Fed's tightening through year-end to be slightly greater than the BOJ's, but is far from pricing in consecutive BOJ rate hikes. The current yen exchange rate level appears to reflect expectations of an increasingly aggressive BOJ policy normalization path, which is more forceful than what the rates market is currently pricing. To sustain the recent rally, not only is a rate hike needed this week, but sufficiently hawkish policy guidance is also required to make consecutive rate hikes possible and narrow the expected U.S.-Japan policy gap. Otherwise, a widening policy gap will expose the yen to downside risks.