Is the US-Japan interest rate differential the culprit? Interpreting the reasons behind the yen's decline and the central bank's interest rate hike game

The Underlying Logic Behind the Yen’s Continuous Decline

Recently, the Japanese yen has been steadily weakening against the US dollar. This is not merely a matter of exchange rate fluctuations but is based on a clear economic logic. The core driver of the yen’s depreciation is the interest rate differential between the United States and Japan. The Bank of Japan has maintained a long-term low-interest-rate policy, while the Federal Reserve has kept relatively high interest rates. This interest rate gap has led to ongoing arbitrage trading—investors borrow low-interest yen and convert it into dollars to earn the interest spread. This mechanism continues to operate, resulting in ample yen supply, insufficient demand, and downward pressure on the exchange rate.

As of November 27, the USD/JPY exchange rate briefly fell below 156, but this was not a trend reversal signal; rather, it was a short-term technical adjustment in the market.

Government Warnings and Rising Expectations of Rate Hikes by the Central Bank

Policy actions are beginning to shift market expectations. On November 26, Japanese Prime Minister Sanae Sato publicly stated that the government would closely monitor exchange rate fluctuations and would take “decisive” action in the foreign exchange market if necessary. Behind this statement is Japanese authorities’ concern over the long-term weakening of the yen. Further sources revealed that the Bank of Japan might announce a rate hike in its December monetary policy decision.

As expectations for rate hikes increase, market sentiment has begun to change. At the time of writing, the USD/JPY has significantly retreated from its highs, reflecting a re-pricing by investors regarding the Bank of Japan’s policy stance.

The Federal Reserve’s Decision Will Be a Key Variable

The critical timing in December is approaching. The Federal Reserve will announce its interest rate decision one week before the Bank of Japan’s meeting, which is scheduled for December 19. The relationship between these two decisions is not coincidental—analysts generally believe that the Bank of Japan’s decision will be significantly influenced by the Fed’s policy direction.

If the Fed maintains its current interest rates, it will exert substantial pressure on the Bank of Japan to hike rates. Conversely, if the Fed chooses to cut rates, the Bank of Japan is more likely to adopt a wait-and-see approach and maintain its current policy for now. Currently, the market assigns about a 50% probability to both rate hikes and delayed hikes.

Australian Commonwealth Bank analyst Carol Kong believes that the Bank of Japan’s actions may be influenced by the approval of the budget bill. “A cautious Bank of Japan might choose to wait until the parliament passes the budget bill before raising rates, which would buy time for future policy adjustments and allow further observation of wage negotiations.”

Can Narrowing the Interest Rate Differential Rewrite the Yen’s Fate?

On the surface, rising expectations for rate hikes should support the yen. If the US-Japan interest rate differential continues to narrow, it will weaken the attractiveness of arbitrage trading and reduce yen short positions. However, UBS forex strategist Vassili Serebriakov poured cold water on this idea: “One rate hike is far from enough to reverse the medium-term trend of the yen.” He pointed out that the US-Japan interest rate differential remains relatively high, and volatility is still low, meaning the downward pressure on the yen has not truly dissipated.

To achieve a substantial appreciation of the yen, the Bank of Japan needs to demonstrate a more hawkish stance—not only raising rates in December but also explicitly committing to continue tightening policies through 2026, effectively controlling inflation and improving the interest rate environment.

Market Intervention Expectations and Currency Battles

Jane Foley, head of FX strategy at Rabobank, proposed an interesting paradox: market fears of Japanese government intervention may itself suppress the upward movement of USD/JPY, thereby reducing the necessity for actual intervention by authorities. In other words, expectations can influence outcomes.

In the short term, the yen’s exchange rate will fluctuate between expectations of rate hikes, Fed decisions, government intervention prospects, and interest rate differentials. The reasons for the yen’s decline have not disappeared, but the market has begun to reprice the possibility of policy shifts. The real turning point depends on the specific actions taken by the Fed and the Bank of Japan in the coming weeks.