As arbitrage trades, which were once popular with investors, collapsed, hedge funds hastily pulled out of their short positions in the Japanese yen. According to the data from the US Commodity Futures Trading Commission (CFTC), hedge funds reduced their net short positions in the Japanese yen by 56,639 contracts in the two weeks ending July 23, which is the largest sell-off since early 2011.

Although hedge funds still hold short positions in the Japanese yen, their bearishness is at its lowest level since February. This marks a stunning shift in market sentiment as expectations grow that interest rates will ultimately tilt in favor of the yen.

Win Thin, global head of foreign exchange strategy at Brown Brothers Harriman & Co., said, "The recent strength in the yen is driven by expectations for the Bank of Japan to make hawkish resolutions this week. If the Bank of Japan's decision disappoints, most of the yen's rebound will quickly reverse."

The Bank of Japan and the US Federal Reserve will announce their interest rate decisions this week in succession. Investors' increasingly bullish yen outlook will be put to the test. The forward exchange rate indicates a 50% chance that the Bank of Japan will raise rates on Wednesday. Any dovish comments from Bank of Japan officials could potentially interrupt the yen's recent rally.

After what appeared to be dual intervention measures by Japanese authorities to prop up the yen earlier this month, the yen has appreciated about 5%. However, Shoki Omori, chief strategist at SuMi TRUST Securities, said, "It's futures investment funds that are closing their short positions in the yen. After the Bank of Japan and the US Federal Reserve make policy decisions this week, the closing will stop and go in the other direction."

The dilemma of raising interest rates looms over the Bank of Japan

As the Bank of Japan's policy meeting approaches, all eyes are on how the Bank of Japan will balance its monetary policy to deal with weak consumer spending and continued inflationary pressures. Bank of Japan officials must find a delicate balance between maintaining economic stability and supporting the yen. Their decisions will not only affect Japan's economic prospects but may also have far-reaching implications for global financial markets.

According to sources familiar with the matter, Bank of Japan officials believe that the decision to raise interest rates this week has become complicated due to weak consumer spending. Some officials lean towards not raising rates in July so that there is more time to examine the upcoming data and confirm whether consumer spending will pick up. However, some officials are willing to raise rates at the July meeting, as they believe that the Bank of Japan's policy rate range of 0% to 0.1% is very low and there is a risk of missing a rate hike opportunity given the many uncertainties in the future.

A media survey released last week showed that only about 30% of Bank of Japan watchers expect the central bank to raise rates at the end of this month, but more than 90% of respondents believe that there is a risk of a rate hike.

It is worth mentioning that another key point of the Bank of Japan's policy meeting this week is how much the central bank will reduce its monthly bond purchases. Analysts expect the Bank of Japan to reduce its bond purchase scale by JPY 1 trillion per month starting in August, down to JPY 5 trillion per month (about USD 32 billion). In the long run, according to the median estimate, the Bank of Japan will reduce its monthly purchase amount to JPY 3 trillion in two years.

Among analysts who expect the Bank of Japan to take no interest rate action this month, many have said that combining rate hikes with the announcement of a quantitative tightening path would cause too much shock and there is too much uncertainty in the market's reaction to the "double action". First Chief Fixed Income Strategist Naomi Muguruma of Mitsubishi UFJ Morgan Stanley Securities said: "It is unlikely that the Bank of Japan will take bold action after spending 1.5 months working out the bond plan to convey its very cautious stance."