Why is the Japanese yen still falling despite BoJ rate hikes?

Van Ha Trinh

Financial markets strategist

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Why does the Japanese yen forecast remain bearish even as the BoJ raises interest rates? Discover the key macroeconomic forces shaping the outlook and why BoJ interest rates may not be enough to reverse the yen's decline.

At first glance, the Japanese yen forecast seems counterintuitive. The Bank of Japan has raised interest rates to their highest level in decades, yet the yen continues to weaken against the US dollar. In my view, the answer lies beyond the BoJ's policy decisions. A widening yield gap, fiscal constraints, capital outflows, and subdued inflation are creating powerful structural forces that BoJ interest rates alone cannot overcome. In this article, I examine why these factors could keep the yen under pressure throughout the rest of the year.

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Key takeaways

The yield gap remains the biggest driver of yen weakness. Higher US interest rates relative to BoJ interest rates continue to fuel carry trades and place pressure on the Japanese yen.
Japan's debt limits aggressive rate hikes. Public debt exceeding 250% of GDP restricts how quickly the BoJ can tighten monetary policy without increasing borrowing costs.
Subsidies are masking inflation pressures. Government price support keeps headline inflation below target, reducing the urgency for further increases in BoJ interest rates.
Capital is flowing overseas instead of supporting the yen. Income from Japan's current account surplus is largely reinvested abroad rather than converted into yen-denominated assets.
The Japanese yen forecast remains bearish. A widening US-Japan interest rate differential, fiscal constraints, and persistent capital outflows could keep the yen under pressure through year-end.

The BoJ raised its deposit rate to 1.00%, marking the highest level in 30 years, yet the yen continues to plunge to a 40-year low. The underlying market dynamics driving this movement include:

Yield differentials pressure the yen

First, the yield differential between US and Japanese government bonds remains wide, sustaining robust yen carry trade activity. This widened significantly after geopolitical conflict in the Middle East drove US inflation to a peak of 4.2% YoY. Although inflation subsequently moderated, re-escalating conflict pushed WTI oil prices back toward 90 USD/barrel, reigniting inflation concerns.

In Japan, government price subsidies keep inflation low at 1.4-1.5%, remaining below the BoJ's 2.0% long-term target. Meanwhile, the recent trade deficit—amplified by the yen's 40-year low—has driven up import prices, which might weigh on economic growth and erode domestic consumer spending. This dynamic may prompt the BoJ to maintain plans to raise rates to 1.25% in December, despite unpredictable developments in the global economy.

Consequently, financial markets expect the Fed to hike interest rates at its September meeting, preceding the BoJ's expected follow-up rate hike in December. As a result, the interest rate differential will widen further, continuing to weigh on the US dollar-yen dynamic.

Chart comparing Fed and BoJ interest rate expectations in 2026, showing a widening yield differential that supports the Japanese yen forecast for continued weakness.

Swap markets expect the Fed to maintain significantly higher interest rates than the BoJ through year-end, widening the yield differential that continues to weigh on the Japanese yen.

High public debt restricts rapid policy tightening

Japan's public debt now exceeds 250% of GDP, representing the highest ratio among advanced economies. This fiscal reality places the BoJ in a strategic dilemma:

If the BoJ aggressively raises interest rates to defend the yen, the Japanese government's debt service costs (interest payments on government bonds) would surge to unmanageable levels, directly threatening national fiscal sustainability.

This constraint leads financial markets to believe that the BoJ cannot raise rates as aggressively or quickly as other central banks. This lack of policy flexibility inadvertently fuels momentum for investors short-selling the yen.

Fiscal stimulus package hinders rate hikes

Currently, price subsidies and tax cuts, such as expanded electricity and gas subsidies alongside economic stimulus packages, distort Japan's inflation figures. Headline CPI hovers around 1.40-1.5% amid oil price turmoil from Middle East tensions. This muted inflation level complicates the BoJ's decision to tighten policy. The BoJ aims to maintain inflation around 2.0%, driven primarily by demand-pull pressure through robust wage growth and consumer spending. However, current figures offer the BoJ no urgency to hike rates; instead, the central bank might maintain a gradual path of raising rates every six months.

Capital outflows counteract current account surplus

Japan continues to report a large current account surplus, which typically boosts demand for the yen as firms repatriate capital. However, the recent current account surplus stems primarily from returns on massive overseas investments. In the previous period, negative interest rates and rising domestic costs prompted Japanese businesses to invest heavily abroad. Although repatriated foreign profits remain abundant, institutions are not converting this capital into yen-denominated assets. Rather, capital continuously flows back into overseas reinvestments held in foreign currencies, leaving the current account surplus unable to support the yen.

Bloomberg models indicate that the yen might continue its decline, with an over 55% probability of dropping to the 165 JPYUSD range and a 34% probability of falling to 170 JPYUSD by year-end. Simultaneously, the yen faces ongoing intervention risks from Japan's MoF. Yet, if the expected interest rate differential remains high, the yen might continue to slide even after absorbing the impact of official interventions.

Chart showing Japan's current account balance since 2000, illustrating how overseas investment income and capital outflows influence the Japanese yen forecast despite a growing surplus.

Japan's current account surplus has reached record highs, but much of the income is being reinvested overseas rather than converted into yen, limiting support for the currency.

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Exness Pro account spreads were 50% lower than the average spreads of 15 other brokers on 28 FX majors and minors, in the week of 5-10 April 2026, comparing the tightest spread-only accounts.

Final thought

In conclusion, the resurgence of tensions in the Middle East has reignited inflation concerns and heightened expectations that the Fed will raise interest rates sooner while the BoJ maintains a slow pace of rate hikes. This dynamic widens the interest rate differential between the US and Japan despite a record current account surplus. Consequently, elevated yen carry trade activity and capital allocation in US assets might maintain immense pressure on the yen through year-end.

Disclaimer: The views expressed in this article are those of the author and are intended for informational purposes only. They do not constitute trading, investment, or financial advice, and readers should conduct their own research before making any financial decisions.