The Bank of Japan raised the key interest rate to the highest level in 30 years, yet the yen fell to record low levels. The result was completely opposite to what Japan desired.
Now the government signals that they may intervene in the currency market, thus uncertainty is growing.
Japan warns of 'appropriate measures' as the yen declines
On Monday, Atsushi Mimura, Japan's Vice Minister of Finance for International Affairs and top currency diplomat, warned that currency trading has recently been 'one-sided and sharp.' He stated that the authorities are ready to take 'appropriate measures' if the changes in the currency market become too large. This is a clear sign that currency intervention may occur. Finance Minister Satsuki Katayama made similar comments at the end of last week. She indicated that Tokyo will respond if currency fluctuations become excessive or speculative.
The warnings came as the yen fell to historically low levels. On Monday, the dollar rose to 157.67 yen. The euro rose to 184.90 yen, and the Swiss franc reached 198.08 yen. Both the euro and the Swiss franc are at record levels against the yen. Many in the market believe that Japanese authorities will intervene if the dollar approaches 160 yen. Last summer, the Bank of Japan sold about 100 billion USD at similar levels to support the yen.
Why is the yen weakening despite an interest rate hike?
Normally, an interest rate hike should strengthen a currency. Higher rates attract foreign money seeking better returns. On December 19, the Bank of Japan raised the policy rate by 0.25 percentage points to 0.75%. This is the highest level since 1995.
Yet the yen weakened. Several factors explain this unusual result.
Firstly, the hike was already priced into the market. Overnight index swaps showed almost a 100% chance that it would happen. Therefore, we saw a classic “buy the rumor, sell the news” reaction. Investors who bought yen before the announcement then sold to take profits, which lowered the yen even further.
Secondly, the actual interest rate is still very negative in Japan. Even though the nominal interest rate is now 0.75%, inflation is 2.9%. This gives a real interest rate of about -2.15%. In the USA, the real interest rate is about +1.44%, with the policy rate at 4.14% and inflation at 2.7%. The difference between Japanese and American real interest rates is over 3.5 percentage points.
The big difference is making yen carry trade popular again. Carry trade means that investors borrow in a country with low interest rates and buy assets with higher returns in another. By borrowing cheap yen and buying assets in USD, traders profit from the interest rate gap. Since the large interest rate differential remains, investors continue to sell yen and buy USD.
Thirdly, Kazuo Ueda, the head of the Bank of Japan, disappointed the market at his press conference. On December 19, Ueda did not provide clear guidance on upcoming interest rate hikes. He stated that there is “no predetermined path for further increases” and that estimates of the neutral interest rate are “very uncertain.” He also downplayed the significance of the decision, saying that the interest rate is at its highest in 30 years, but that it “does not have any particular significance.” The market interpreted that the Bank of Japan is in no hurry to raise rates further. This caused the yen to fall even faster.
Japan's structural dilemma
Robin Brooks, a senior researcher at the Brookings Institution, highlights a deeper problem. “Japan's long-term interest rates are far too low given the large national debt,” he writes. “As long as this is the case, the yen will continue to weaken.”
Japan's national debt stands at 240% of GDP, but Japan's 30-year government bond has roughly the same yield as Germany's, despite Germany having much less debt. This is unusual. The Bank of Japan has kept rates low by purchasing large amounts of government bonds.
“Without these purchases, Japan's long-term interest rates would be much higher, which could drive the country into a debt crisis,” says Brooks. “Given how large the debt is, the choice is between a debt crisis or the yen continuing to weaken.”
Brooks also says that when comparing actual exchange rates, the yen is now almost as weak as the Turkish lira, which is one of the world's weakest currencies.
The pressure is also increasing as Prime Minister Sanae Takaichi has embarked on large stimulus measures since October. It is Japan's largest stimulus package since the COVID-19 pandemic. Since the national debt is already 240% of GDP, the market is becoming worried that increased government stimulus could counteract the Bank of Japan's attempts to stabilize the currency.
Market impact: Short-term relief, growing uncertainty
Since the yen is weakening despite the interest rate hike, the world's stock markets feel a temporary relief – for now.
In theory, an interest rate hike should strengthen the currency and force investors to unwind carry trades. If that happens, investors sell assets that have been borrowed with yen, which drives down prices of stocks and cryptocurrencies, for example.
But the reality looks different. The weakness of the yen is causing carry trades to increase again instead of being unwound.
Japanese stocks benefit. The Nikkei rose 1.5% on Monday as the weaker yen increased profits for exporters like Toyota. Profits abroad are then converted into more yen. Japanese bank stocks have risen by 40% this year. Many believe that higher interest rates will make banks more profitable.
Safe assets are rising as well. Silver hit a record high and was sold for $67.48 per ounce, which is an increase of 134% so far this year. Gold remains strong, with a price of $4,362 per ounce.
But this relief is uncertain. It is based on the assumption that the Bank of Japan does not give any clear signals about its policy. If Japanese authorities intervene in the currency market or if the Bank of Japan quickly raises rates more than expected, the yen could strengthen quickly. Then investors would have to unwind their carry trades quickly, which could drag down asset prices around the world.
We have seen this before. In August 2024, when the Bank of Japan raised interest rates without warning, the Nikkei fell by 12% in one day. Bitcoin crashed at the same time. Bitcoin has fallen 20–31% after each of the last three interest rate hikes from the Bank of Japan.
Outlook: 160 yen is the limit
In the short term, the market believes that the dollar-yen will end the year around 155 yen. During the Christmas holiday, there are few traders, so there will be less volatility.
But if the pair goes above 158 yen, it could test this year's high of 158.88 yen and then last year's peak of 161.96 yen. The risk of Japanese intervention increases rapidly as the exchange rate approaches 160 yen.
Experts disagree on the timing of the next interest rate hike from the BOJ. ING predicts a hike in October 2026, while Bank of America sees June as more likely. They do not rule out April if the yen weakens quickly. BofA analysts believe that the terminal interest rate will reach 1.5% by the end of 2027.
Some analysts still warn that these forecasts may not be enough. The US interest rate is still above 3.5%, while the BOJ is only at 0.75%. The interest rate difference is therefore too large for the yen to strengthen significantly. To stop the yen’s decline, the BOJ likely needs to raise interest rates to at least 1.25–1.5%, along with more cuts from the Fed. But that scenario does not seem likely soon.
Japan must therefore balance between currency depreciation and a debt crisis. Brooks warned that “the political consensus on budget tightening does not exist yet. Yen depreciation must get worse before that happens.”
The world's markets therefore need to be prepared for Japan to create fluctuations in the coming months.