The Japanese stock market is currently navigating through turbulent waters as expectations of interest rate hikes from the Bank of Japan loom over itHowever, analysts at Bank of America (BofA) suggest that investors may be overreacting to what is largely perceived as bad news, asserting that much of the potential fallout has already been factored into current market valuations.

In a report issued on January 17, BofA's Japan investment strategist, Masashi Akutsu, and his team identified three main pressures that the Japanese equity market is grappling with this year:

  1. The sharp rise in U.Slong-term bond yields.
  2. The rekindling of expectations surrounding a potential rate hike from the Bank of Japan in January.
  3. The overarching uncertainty of U.Sgovernment policies.

Despite these challenges, BofA maintains that the anticipated increases in both U.S

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interest rates and Japanese rates have likely been incorporated into the market, with the unpredictability of U.Spolicies remaining the most significant source of riskThe analysts clarified that until an official announcement is made by the government concerning its policy changes, particularly those related to tariffs, there exists an inherent risk of market correctionNevertheless, the analysts believe that unless tariffs exceed expectations in breadth, the Japanese stock market is unlikely to experience any substantial declines due to its currently low valuations.

Furthermore, BofA dissected the future of the Japanese stock market amid these ongoing pressures, pointing out that while various risks abound, their resolution does not immediately guarantee a significant rebound in stock pricesIn the most favorable scenario, all negative news could potentially be absorbed by the market within the week

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They also indicated that, even if a decline were to occur in the immediate term, there's a strong possibility that the market will rebound from January to March, driven by several key factors:

  • A robust performance by listed Japanese companies in the third quarter, reflecting solid operational health and growth potential.
  • A high likelihood of substantial wage increases emerging from the spring labor negotiations in March, which would act as a stimulus for consumer spending and invigorate the economy.
  • Proactive reform measures from numerous companies ahead of their annual performance announcements, expected to enhance efficiency and competitiveness, supporting price increases in the stock market.

Moreover, BofA noted that the rapid increase in U.Slong-term interest rates appears to have stabilized, which should alleviate some of the pressure on Japanese stocks

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They highlighted that, according to the latest data, consumer price index (CPI) figures from the U.Sfor December 2024 are showing signs of easing inflationThis shift could suggest a pause in the previously relentless upward trend in U.Sinterest ratesThough the U.Seconomy continues to exhibit strong fundamentals, characterized by a stable job market and healthy corporate profitability, this shift toward stabilizing prices signifies a potential change in market focus—from merely economic growth and interest rates to rising productivity.

Additional commentary from BofA conveyed that the swift rise of U.Slong-term rates had largely been driven by an increase in term premiums, a phenomenon not easily attributed simply to shifts in market expectations concerning Federal Reserve rate cutsThey elaborated that when term premiums rise, and financial conditions tighten, investors tend to unload previously high-flying stocks and shares with high beta values, while favoring low-volatility defensive stocks as safe havens.

Market sentiment appears to be moderating now, suggesting a relaxing of risk aversion among investors

This shift indicates that following a period of significant volatility, the market might be entering a phase of relative calm.

On the domestic front, heightened expectations for a rate increase from the Bank of Japan have emergedThis surge in expectations coincided with statements from Bank of Japan’s Vice Governor, Ōshima Yoshihide, and Governor Ueda Kazuo, who spoke on January 14 and 15, leading market speculation for a rate hike in January to spike from 40% to over 80%.

Analysts suggest that the BoJ may choose to hike rates in January to avoid overlapping with any prospective rate cuts by the Federal ReserveBofA reiterated that should the Bank of Japan follow through with the anticipated rate hike, it is unlikely that the Japanese market would replicate the steep declines experienced in July 2024. At that time, Japanese stocks fell sharply due to significantly deteriorating U.S

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employment data and the unwinding of yen carry trades, circumstances which are not present now—especially given that recent U.Semployment data shows a positive trajectory.

Thus, BofA underscored that even if the BoJ does proceed with a rate hike in January, the market could very well find itself in a position where "all bad news has been digested."

In conclusion, BofA cautioned that the largest source of uncertainty for the Japanese stock market arises from developments post-January 20, particularly in relation to tariff policiesGiven the current state of market pricing on potential tariffs remains insufficient, the possibility of market corrections cannot be ruled outHowever, the analysts contend that given the low valuations currently characterizing the Japanese market, substantial declines are not likely unless any new tariff measures exceed expectationsFollowing any corrections, the market may swiftly recover.