Yen weakness despite higher interest rates
- Yen stayed weak despite a historic rate hike: The Bank of Japan raised rates to 0.75% (highest since 1995), but deeply negative real interest rates (about –2.15%) continue to erode yen purchasing power and discourage investment in the currency.
- Markets had fully priced in the hike: The decision was expected with near-100% probability, triggering a “buy the rumor, sell the news” reaction as investors took profits, adding selling pressure on the yen instead of supporting it.
- Global rate differentials favor the dollar over the yen: A large real interest rate gap dovish signals from BOJ Governor Ueda, and strong risk appetite for U.S. assets have revived carry trades and pushed USD/JPY higher.
The end of 2025 brought a phenomenon to financial markets which some investors could call a "paradox". At its center was Japan, attempting to finally break away from the legacy of decades of monetary stagnation, and the yen, which behaved in a way that ran counter to textbook economic intuition. Despite an interest rate hike, the Japanese currency failed to strengthen and instead remained weak against the world’s major currencies.
The end of the ultra-low rate era – or not quite?
For decades, Japan operated under an ultra-loose monetary policy aimed at combating deflation. December 2025 was meant to mark a turning point. Inflation in the Land of the Rising Sun had remained above the Bank of Japan’s 2% target for 44 consecutive months, reaching 2.9% year over year in November. Even so, following the December decision, monetary policy remained firmly in stimulative territory. The Bank of Japan emphasized in its statement that real interest rates would remain significantly negative and that financial conditions would continue to support economic growth.
It is precisely these negative real interest rates that provide the key to understanding the yen’s persistent weakness. With inflation at 2.9% and the nominal policy rate at 0.75%, Japan’s real cost of money stands at approximately –2.15%. This implies an ongoing erosion of purchasing power for yen-denominated cash holdings, structurally discouraging investors from accumulating the Japanese currency.
A decision fully priced in by markets
On December 19, 2025, the Bank of Japan’s Policy Board unanimously decided to raise the policy rate to 0.75%, the highest level since 1995. While historically significant, the move came as no surprise to financial markets. Investors were well prepared: the overnight index swap (OIS) market had priced in the hike with near 100% probability ahead of the meeting.
As a result, the classic market mechanism of “buy the rumor, sell the news” came into play. Investors who had positioned for yen appreciation ahead of the decision moved to take profits once the announcement was made, generating selling pressure on the currency immediately afterward.
USD/JPY reaction contrary to expectations
At the same time, investor attention was focused on the United States. For many months, the Federal Open Market Committee refrained from cutting interest rates due to concerns that inflation could reaccelerate amid tariff policies implemented by the Donald Trump administration. From December 2024 through September 2025, the Fed maintained its benchmark rate in the 4.25–4.50% range.
The turning point came from labor market data pointing to both declining employment and a rising unemployment rate, which ultimately provided the key argument for initiating rate cuts. Since then, the interest rate range has fallen to 3.5-3.75%. Meanwhile, U.S. inflation remained above the Federal Reserve’s target, with the November CPI reading at 2.7% year over year. However, this figure came in well below market expectations of 3.1%.
This disinflationary surprise, rather than weakening the U.S. dollar, fueled a strong increase in risk appetite. Global capital flowed into U.S. equities and the dollar, rather than into the yen, traditionally viewed as a safe-haven currency. As a result, USD/JPY rose instead of falling following Japan’s rate hike.
Ueda's press conference signals a dovish monetary policy
A further blow to bullish yen sentiment came from Governor Kazuo Ueda’s press conference. Instead of signaling an aggressive fight against inflation, markets heard a series of cautious and conservative messages. Ueda emphasized that there was no predetermined path for further rate hikes and acknowledged that estimates of the neutral interest rate remain highly uncertain.
He also downplayed the historical significance of the decision, stating that reaching the highest interest rate level in 30 years “has no special meaning.” This rhetoric was interpreted as distinctly dovish, reinforcing expectations that the Bank of Japan is in no rush to accelerate monetary tightening and further cooling investor enthusiasm for the yen.
Yen Weakness Versus Major Currencies
The combined effect of these factors has been a continued weakening of the yen against major currencies. The decisive factor is the stark disparity in real interest rates. While Japan’s real rate remains deeply negative, the U.S. real rate stands at approximately +1.44%, based on bond yields around 4.14% and inflation at 2.7%.
This gap of more than 3.5 percentage points has revived carry trade strategies, in which investors borrow in low-yielding yen to invest in higher-yielding U.S. dollar assets. Until the Federal Reserve embarks on aggressive rate cuts or the Bank of Japan significantly accelerates its tightening cycle, the fundamental gravitational pull of global markets is likely to continue favoring the dollar at the expense of the yen.
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