Japanese equities have had a good run. And that’s an understatement.

An entire generation of investors witnessed the first Nikkei record of their adult lives last month.

The rapidity of the advance was remarkable, albeit not as historic as the milestone itself.

Local shares surged more than 20% in the summit push, rivaling the best three-month advances of the post-COVID era.

Market participants spun a rosy fundamental narrative to justify the rally as investors are wont to do in the heat of the moment. As I wrote in February, Japanese shares are famously cheap, and there’s plenty of scope for corporates to return more cash to shareholders. Buybacks in Japan hit a record for a second straight year in 2023. From a macro perspective, the Japanese economy is “normalizing,” where that means the deflationary mindset may finally be breaking. Some believe wages are entering a period of sustainable growth. And so on.

There are (at least) two caveats. First, the Japanese economy’s hardly booming. Although revisions released Monday showed Japan didn’t enter a recession in Q4 after all, the 0.4% expansion doesn’t exactly count as robust. Notably (and this is the second caveat), the GDP revisions suggested corporate spending was solid last quarter, a result that’ll probably embolden the BoJ in their quest to end the world’s last remaining negative rates regime.

Japanese shares fell the most in more than five months on Monday coming off the yen’s best week since last summer (illustrated below).

The currency (and local bond yields) advanced as the better read on growth stoked speculation that the end of NIRP and, perhaps, the end of yield-curve control too, is upon us.

The obvious question is whether recent gains for Japanese equities were really just a combination of a weaker yen and FOMO, not widespread faith in the fundamentals. If that’s the case, investors will need to square their positions (figuratively and literally) with an incrementally less forgiving policy backdrop. Japan’s the only developed economy not poised to ease monetary policy this year. Indeed, Japan’s going to be tightening policy at a time when the Fed, the ECB and the BoE are set to cut rates.

“Yen weakening in recent years has provided a meaningful boost to Japanese equities as the Nikkei 225 has rallied 55% in the past 14 months,” JonesTrading’s Mike O’Rourke remarked. “Now the environment will be shifting to one in which the BoJ is the only major developed central bank that is tightening policy as other central banks are preparing to ease.”

Japanese equity funds have seen inflows every week this year but one.

Suffice to say any knock-on yen strength from the unfolding policy shift (and the divergence it creates with the BoJ’s counterparts across the developed world) will be a litmus test for the local equity rally: Were investors really buying into a better fundamental underlying macro story or was the surge just another example of traders chasing the hottest market, amplified by local currency weakness and an exodus of money from Xi Jinping’s “uninvestable” China?

And what happens to the BoJ’s ETF-buying program once the central bank starts the normalization process in earnest? Surely it’ll be mothballed. But what about the giant portfolio? Stocks don’t “mature.” Are they going to sell?

I suppose we’ll find out. Because a rate hike from Kazuo Ueda is imminent. Late last week, Reuters said policymakers are leaning towards a hike at this month’s meeting pending the results of annual wage negotiations to be released by the country’s largest union group later this week. And according to Jiji Press, YCC may be formally jettisoned this month too.

For the past three years, the BoJ bought equity ETFs every single time the Topix fell at least 2% during the morning session. On Monday, as Japanese shares slipped, there was no sign of the BoJ.