The Bank of Japan raised the interest rate to the highest level in the last 30 years, but instead of strengthening, the yen plummeted to record lows. The outcome was directly opposite to what the authorities had expected.
Now the government is increasingly signaling possible intervention in the currency market, which only adds to the uncertainty.
Japanese authorities hint at intervention in the currency market
Atsushi Mimura, Deputy Minister of Finance for International Affairs in Japan, called the recent movements in the FX market 'one-sided and sharp.' According to him, if the exchange rate fluctuations become excessive, the authorities are ready to act. That is, intervention in Tokyo is not ruled out.
A similar position was voiced at the end of last week. Finance Minister Satsuki Katayama indicated that authorities would not ignore speculative pressure on the yen.
The reason is obvious: the yen is hitting new lows. On Monday, the dollar reached 157.67 yen, the euro 184.90 yen, and the franc 198.08 yen. The market views the level of 160 yen per dollar as a point where intervention becomes almost a baseline scenario. Last summer, the Bank of Japan already defended the exchange rate, selling about $100 billion.
Why is the yen weakening despite the rate hike?
In a normal situation, an increase in interest rates supports the currency. Higher yields attract foreign capital. On December 19, the Bank of Japan raised the key rate by 0.25 percentage points to 0.75%, the highest level since 1995.
However, the market reacted oppositely. The yen began to decline, and this is not due to a single factor.
The rate hike was not a surprise. The market had almost fully priced in this decision in advance. After the announcement, many investors began to lock in profits on yen positions, which immediately intensified pressure on the exchange rate.
At the same time, real rates in Japan remain negative. The nominal rate has risen to 0.75%, but inflation is around 2.9%. As a result, the real yield is about -2.15%. The situation is different in the US. There, real rates remain positive, and the gap between yields exceeds 3.5 percentage points.
This imbalance has once again made the carry trade involving the yen attractive. Investors continue to borrow yen at low rates and invest in dollar-denominated assets with higher yields. As long as the rate differential persists, demand for yen remains weak.
An additional factor was the speech by the head of the Bank of Japan, Kazuo Ueda. At a press conference, he did not provide clear signals on the timing of the next rate hikes and emphasized that there is no predetermined course for further tightening. Moreover, he effectively downplayed the significance of the current decision, stating that reaching the maximum level of rates in 30 years is not particularly important.
The market perceived this as a signal that the Bank of Japan is in no hurry to take further steps. After that, the sell-off of the yen only accelerated.
Japan's structural dilemma
According to economist Robin Brooks, a senior fellow at the Brookings Institution, the problem runs much deeper than a single rate decision.
“Long-term interest rates in Japan are too low given the gigantic national debt. As long as this is the case, the yen will continue its devaluation cycle,” he wrote.
Japan's national debt is around 240% of GDP, while the yield on 30-year bonds is approximately at the level of Germany, a country with a significantly lower debt burden. Such a situation looks anomalous. The Bank of Japan artificially suppresses yields by buying huge volumes of government bonds.
“Without these purchases, long-term rates in Japan would be significantly higher, and this would quickly drag the country into a debt crisis. Unfortunately, with such a scale of debt burden, the choice comes down to two options: either a debt crisis or currency devaluation,” explains Brooks.
Brooks also notes that in terms of the real effective exchange rate, the yen is already competing with the Turkish lira for the title of the weakest currency in the world.
Additional pressure is also created by budget policy. Since October, after taking office, Prime Minister Sanae Takahichi has pursued an aggressive fiscal stimulus course. This is the largest support package for the economy since the COVID-19 pandemic.
With a national debt level of 240% of GDP, markets are increasingly concerned that easing budget policy could undermine the Bank of Japan's efforts to stabilize the national currency.
Market reaction: a brief pause and increasing uncertainty
The weakening of the yen despite the rate hike has given global asset markets a reason to breathe easy. At least for now.
In theory, an increase in rates should strengthen the currency and trigger a winding down of the carry trade. Investors are closing loans in yen, selling global assets, liquidity is leaving the markets, and prices for risky assets, including stocks and cryptocurrencies, are falling.
But in practice, the opposite is happening. As the yen continues to weaken, the carry trade is not unwinding; on the contrary, it is reviving.
The Japanese stock market is benefiting from this dynamic. On Monday, the Nikkei index rose by 1.5% as the weak yen increases exporters' profits, including Toyota. Foreign revenue, when converted to yen, becomes higher. Shares of Japanese banks have gained about 40% since the beginning of the year, reflecting expectations of growth in their profitability amid rising rates.
Protective assets are also rising. Silver has hit a historical high, reaching $67.48 per ounce. Year-to-date, the increase is 134%. Gold is holding at high levels of around $4,362 per ounce.
However, this pause rests on shaky foundations. It pertains to ‘uncertain calm’ that has arisen due to the lack of clear signals from the Bank of Japan. If authorities intervene in the currency market or the regulator starts raising rates faster than expected, the yen could strengthen sharply. This would provoke a rapid unwinding of the carry trade and pull global asset markets along.
The precedent is fresh. In August 2024, the Bank of Japan raised rates without a clear prior signal. As a result, the Nikkei collapsed by 12% in one day, and Bitcoin fell alongside it. After each of the last three rate hikes by the Bank of Japan, Bitcoin lost between 20% and 31%.
Why does the 160 yen mark scare the markets?
In the near term, the market is pricing the dollar-yen exchange rate around 155. The holiday period and low trading volumes are likely to restrain sharp movements.
The situation may change if the exchange rate rises above 158 yen. In that case, the market will quickly shift to this year's highs and last year's peak around 162 yen. As it approaches the level of 160 yen, discussions of currency intervention become increasingly substantive.
Estimates for the next move by the Bank of Japan vary. ING expects a rate hike no earlier than October 2026. Bank of America considers June more likely and allows for April if pressure on the yen intensifies. At BofA, they believe that by the end of 2027, the rate could reach 1.5%.
However, some analysts doubt that this will be enough. While rates in the US remain above 3.5%, and the Bank of Japan's rate is at 0.75%, the gap remains too large. In such conditions, it is difficult for the yen to recover. A reversal of the trend would require a rate increase to at least 1.25–1.5% and a simultaneous decrease in the Fed's rates. In the near term, such a scenario seems almost unrealistic.
As a result, Japan finds itself between two extremes: currency devaluation and the risk of a debt crisis. As Brooks notes, there is currently no political willingness for strict budget consolidation, which means pressure on the yen is likely to continue.
For global markets, this means one thing. The Japan factor remains a source of potential volatility that will need to be monitored closely in the coming months.
