The Bank of Japan has raised interest rates to the highest level in 30 years, but the yen still fell to an all-time low. This is exactly the opposite of what Japan wanted to achieve.
As the government may intervene in the currency market, uncertainty is only increasing.
Japan warns of 'appropriate action' as yen falls
On Monday, Atsushi Mimura, Japan's Vice Minister of Finance for International Affairs and chief currency diplomat, warned that recent movements in the currency market were 'one-sided and sharp.' He said that authorities would take 'appropriate measures' if the exchange rate moves too much – a clear signal that intervention in the currency market is possible. Finance Minister Satsuki Katayama made similar remarks late last week, stating that Tokyo will respond to extreme and speculative exchange rate movements.
These warnings came after the yen reached a historic low. On Monday, the dollar rose to 157.67 yen. The euro reached 184.90 yen and the Swiss franc went to 198.08 yen – both all-time lows for the Japanese currency. Market participants believe that Japan will likely intervene if the dollar approaches 160 yen. Last summer, the BOJ sold about $100 billion at similar levels to support the currency.
Why is the yen weakening despite an interest rate hike?
Normally, an interest rate hike leads to a stronger currency. A higher interest rate attracts foreign capital, as investors can get more return there. On December 19, the BOJ raised its interest rate by 0.25 percentage points to 0.75%, the highest level since 1995.
Still, the yen moved in the opposite direction. There are a few reasons for this situation.
First, the interest rate hike had already been fully priced in. The overnight index swap market had estimated nearly 100% chance of this step beforehand. As a result, we saw a typical "buy the rumor, sell the news" effect. Investors who had bought yen in anticipation of the interest rate hike sold them again as soon as the decision was announced to take profits. This created additional pressure on the currency.
Secondly, real interest rates are still deeply negative in Japan. The nominal interest rate has risen to 0.75%, but inflation stands at 2.9%. Therefore, the real interest rate – which is the nominal interest rate minus inflation – is about -2.15%. In the US, the real interest rate is around +1.44%, with an interest rate of 4.14% and inflation of 2.7%. The difference between the real interest rates in Japan and the US is thus more than 3.5 percentage points.
Due to this large difference, the yen carry trade is popular again. In a carry trade, investors borrow money in a country with a low interest rate and invest it in assets with a higher interest rate. By borrowing cheap yen and investing in US dollar assets, traders benefit from the interest rate differential. Because the real interest rate in the US is much higher than in Japan, investors are selling yen again to buy dollars.
Thirdly, BOJ Governor Kazuo Ueda disappointed the market at his press conference. On December 19, Ueda did not provide clarity on when there would be further interest rate hikes. He stated that "there is no fixed plan for further increases" and indicated that the estimate of the neutral interest rate level is "very uncertain." He also downplayed the interest rate increase, stating that reaching the highest level in 30 years "had no special significance." The market saw this as a sign that the BOJ would not raise rates further anytime soon, causing the yen to decline even further.
Japan's structural dilemma
Robin Brooks, a senior fellow at the Brookings Institution, points to a deeper problem. "The long-term interest rate in Japan is far too low given the enormous government debt," he writes. "As long as that remains the case, the yen will continue to decline in value."
Japan's government debt is 240% of gross domestic product (GDP), but the yield on the 30-year government bond is about the same as in Germany – where the debt is much lower. This is not normal. The BOJ keeps interest rates artificially low by purchasing large amounts of government bonds.
"Without those purchases, long-term interest rates in Japan would be much higher, which would plunge the country into a debt crisis," explains Brooks. "Unfortunately, as long as Japanese debts remain so high, the choice is between a debt crisis or further depreciation of the currency."
Brooks says that the yen based on the real effective exchange rate is now as weak as the Turkish lira – the weakest currency in the world.
Moreover, Prime Minister Sanae Takaichi is putting more pressure by spending significantly more money since she took office in October. This is Japan's largest stimulus package since the coronavirus pandemic. With government debt already at 240% of GDP, investors are increasingly concerned that the government's looser budget plans undermine the BOJ's efforts to stabilize the currency.
Market impact: short-term relief, growing uncertainty
Because the yen continues to weaken despite the interest rate hike, global markets can breathe a sigh of relief for now.
In theory, an interest rate hike should strengthen the currency and lead to a reduction in carry trade. Investors who quickly repay their yen loans then sell global assets. This results in less liquidity and lower prices for risky assets like stocks and cryptocurrencies.
But in reality, the opposite is happening. Because the yen remains weak, the carry trade continues to exist.
Japanese stocks benefit from this. The Nikkei rose by 1.5% on Monday, as a weak yen increases the profits of exporters like Toyota (as foreign revenues are converted back into yen). Japanese bank stocks have already risen 40% this year, as investors hope that higher interest rates will improve bank profits.
Safe havens continue to perform well. The silver price reached an all-time high of $67.48 per ounce, bringing this year's profit to 134%. Gold remains strong at $4,362 per ounce.
Still, this relief is fragile. It is a "volatile calm," as the BOJ does not set a clear course. If the Japanese government intervenes in the currency market or the BOJ raises rates faster than expected, the yen could suddenly rise sharply. Then the carry trade could be quickly unwound, which could drag global assets like stocks and crypto down with it.
This recently happened. In August 2024, when the BOJ unexpectedly raised interest rates without prior warning, the Nikkei plummeted by 12% in one day, and Bitcoin also crashed. Bitcoin has fallen by 20-31% during the three previous interest rate hikes by the BOJ.
Expectation: 160 yen is the limit
In the short term, markets expect dollar-yen to close the year around 155 yen. Due to thin trading during the Christmas holiday, volatility remains limited.
But if the currency pair rises above 158 yen, it could test this year's high of 158.88 yen, and then last year's high of 161.96 yen. The likelihood of Japanese intervention increases significantly as the percentage approaches 160 yen.
Expectations for the next interest rate hike by the BOJ are mixed. ING anticipates a rate hike in October 2026, while Bank of America finds June more likely—and does not rule out April if the yen weakens quickly. According to BofA analysts, the terminal rate will reach 1.5% by the end of 2027.
Yet some analysts warn that even these expectations may not be enough. Since US interest rates remain above 3.5% and the BOJ rate is only at 0.75%, the interest rate differential remains too large for a real recovery of the yen. To stop the yen's decline, the BOJ would need to raise rates to at least 1.25-1.5%, along with additional rate cuts from the Fed—a scenario that seems unlikely in the short term.
Japan is balancing on a thin line between currency devaluation and a debt crisis. Brooks warned that "there is still no political support for stricter budgetary policies. The devaluation of the yen is likely to get worse before that happens."
Global markets need to remain alert for volatility coming from Japan in the coming months.
