Why does the yen depreciate despite the central bank raising interest rates? Why hasn't Japan's interest rate policy triggered a strong yen?

The Bank of Japan announced a 25 basis point rate hike on December 19, raising the policy interest rate to 0.75%, reaching a nearly 30-year high. However, what surprised the market was that this “hawkish” move not only failed to support the yen but instead led to a weakening of the yen in the foreign exchange market, with the yen against the Chinese yuan also under pressure.

Rate Hike by the Central Bank Turns Out to Be Negative for the Yen? The Interest Rate Differential Paradox Emerges

On the surface, Japan’s continued interest rate hikes should attract arbitrage trading and push up the yen. But the reality is quite the opposite—the USD/JPY exchange rate has risen, and demand for the yen has not increased.

ANZ Bank analyst Felix Ryan pointed out that the fundamental reason for this phenomenon lies in the interest rate differential environment. Although the Bank of Japan has begun a rate hike cycle, the Federal Reserve remains relatively accommodative, and the interest rate advantage still favors the dollar. In this context, investors, considering interest rate arbitrage, still prefer holding dollars over yen. The institution forecasts that USD/JPY will rise to 153 by the end of 2026.

Lack of Guidance Disrupts Market Expectations

It is worth noting that Governor Ueda did not provide a clear timetable for the next rate hike at the press conference. He emphasized that it is difficult to determine the neutral interest rate level in advance (currently estimated to be between 1.0% and 2.5%) and plans to make adjustments when conditions permit.

This ambiguous policy stance has been interpreted by the market as “mildly dovish.” Strategist Masahiko Loo of State Street Global Advisors said that the market initially expected more aggressive policy signals, but the central bank’s cautious wording led participants to view this rate hike as relatively conservative. The institution maintains a medium-term target of 135-140 for USD/JPY.

Expectations of Further Rate Hikes After 2026 Still Exist, but Cannot Shake Yen’s Downward Trend

Overnight index swap markets reflect that investors generally expect the Bank of Japan to raise rates to 1.00% around the third quarter of 2026. Nomura Securities believes that only if the guidance explicitly indicates that rate hikes could be brought forward to April 2026 or earlier, will the market truly be triggered to buy the yen. Otherwise, without significantly raising the neutral rate estimate, the central bank will find it difficult to convince the market that the final interest rate will be higher.

In other words, the key is not the rate hike itself but policy certainty. The outlook for the yen against the Chinese yuan and other G10 currencies largely depends on whether the Bank of Japan can release clearer, more hawkish forward guidance. Until then, interest rate differentials will continue to suppress the yen’s performance.