Why does the yen depreciate after the Bank of Japan raises interest rates? Why is the market's expectation for a rate hike in 2026 insufficient?

Rate Hikes Can’t Stop the Yen’s Decline

On December 19, the Bank of Japan (BOJ) proceeded with its expected rate hike plan, raising the benchmark interest rate from 0.5% to 0.75%. This is the first time since 1995 that Japan’s interest rate has reached this level. However, unexpectedly, after the rate hike announcement, the USD/JPY exchange rate did not rise significantly as anticipated; instead, it remained at a relatively high level, and the market’s yen buying did not materialize as expected.

Lack of Clear Forward Guidance from the Central Bank

The phenomenon of “rate hikes not boosting the currency” stems from BOJ Governor Ueda Kazuo’s overly cautious statements during the press conference. He did not specify a concrete timing for the next rate hike but emphasized that interest rate decisions depend on actual economic and price data. What disappointed the market even more was that the central bank did not make any substantive commitments to adjust the neutral interest rate level (currently estimated to be in the range of 1.0% to 2.5%).

Market Doubts About the Pace of Rate Hikes

ANZ Bank strategist Felix Ryan pointed out that although the BOJ has begun its rate hike cycle, investors remain skeptical about the strength and frequency of subsequent hikes. He noted that even though the market generally expects the BOJ to continue raising rates into 2026, the interest rate differential between the US and Japan remains clearly unfavorable — the Federal Reserve maintains an accommodative stance, while Japan faces a moderate inflation environment. This puts the yen at a disadvantage in terms of relative returns. The bank forecasts that by the end of 2026, the USD/JPY exchange rate could reach 153.

Foreign Investors Remain Cautious About the Medium-Term Outlook for the Yen

DFA Investment Management strategist Masahiko Loo believes that the market interprets this rate hike as a relatively dovish stance, which could lead to increased yen volatility in the short term. Driven by the Federal Reserve’s relatively loose monetary policy and Japanese domestic investors increasing their foreign exchange hedging ratios from historic lows, the firm maintains a medium-term target of 135-140 for USD/JPY.

When Will Market Buying Be Triggered?

According to overnight index swap (OIS) market pricing, investors expect the BOJ to raise interest rates to around 1.0% at the earliest in the third quarter of 2026. Nomura Securities pointed out that to trigger a genuine hawkish market reaction and yen buying, the BOJ needs to send a stronger signal — implying that the timetable for rate hikes could be significantly moved forward (for example, before April 2026). Without a substantial upward revision of the neutral rate estimate, it will be difficult for the governor’s words alone to reverse the market’s pessimistic expectations about the terminal rate.

Outlook and Insights

The current situation reflects deep skepticism in the market regarding the BOJ’s policy stance. Whether the yen can escape recent depreciation pressures depends critically on whether the BOJ can demonstrate a more decisive attitude in upcoming decisions, and how the global economic landscape further evolves.