The yen broke below the 156 mark overnight as the Federal Reserve’s hawkish rate hikes pushed the Bank of Japan to a “high-pressure moment.”

After the Federal Reserve took hawkish rate hike measures, the Japanese yen fell sharply, raising the risk level of the Bank of Japan's policy meeting on Friday. Strategists warn that unless officials can convince the market that further monetary tightening is ahead, the yen may continue to weaken.

On Wednesday, the Federal Reserve implemented its first rate hike since 2023 and expects more hikes to come, prompting traders to bet on three more rate increases before the middle of next year. This could mean the US-Japan interest rate differential remains wide, even though markets expect the Bank of Japan to raise its policy rate this week.

As a result of the Federal Reserve's action, the yen dropped as much as 1% in overnight trading, to 156.42 yen per US dollar. Earlier this month, the yen had staged a strong rebound, driven by market expectations of faster tightening from the Bank of Japan, the unwinding of yen-funded carry trades, and speculation that Japanese pension funds might shift more funds toward domestic assets.

Glenn Yin, Head of Research at ACCM in Melbourne, said: "Japan is undoubtedly under huge pressure, needing to raise rates while also sending a hawkish signal to minimize losses." If the Bank of Japan disappoints, "the risk of reaching the 160 mark in the short term cannot be written off."

The bar is high. Overnight index swaps have almost fully priced in a 25 basis point hike, shifting traders’ focus to the post-meeting press conference by Bank of Japan Governor Kazuo Ueda for clues about the pace and extent of further tightening. Hawkish committee member Hajime Takata has even left room for an outsized or consecutive rate hike.

Rinto Maruyama, Senior Rates and FX Strategist at SMBC Nikko Securities, said the yen’s renewed decline gives the Bank of Japan greater reason to emphasize the risks of higher inflation. He noted that rising oil prices could provide policymakers with more grounds to further tighten stance.

Maruyama said Friday’s expected rate hike would bring Japan’s policy rate within the estimated neutral range, making it unlikely that officials would signal a 50 basis point hike or consecutive increases. He believes that if this meeting is interpreted as dovish, 158 would be the next upside target for USD/JPY.

This means that if investors conclude the Bank of Japan’s tightening cycle cannot keep pace with the Federal Reserve, the yen will remain vulnerable. Maruyama believes that, over time, if US rates rise faster than Japan’s, USD/JPY could gradually rebound toward 160.

That said, there are reasons to expect that a new round of yen selling may not be as fierce as before. Carry traders have been burned by the yen’s recent rebound, and hedge funds have already cut short positions. According to US Commodity Futures Trading Commission data, in the week ending September 8, leveraged traders halved their bearish bets on the yen.

The threat of renewed intervention may also curb depreciation of the yen. Japan and the US have shown willingness to act jointly in the market, and US Treasury Secretary Janet Yellen continues to send signals supporting a stronger yen.

Friday’s rate hike may not be enough to support the yen. Akira Moroga, Chief Market Strategist at Aozora Bank, said the Bank of Japan "may not take as hawkish a stance as the Federal Reserve, which could be the direct catalyst for the yen’s weakness." He believes the next key level is near the 200-day moving average at 158.50 yen per US dollar.