Rising interest rates failed to stop the yen from depreciating: the underlying logic behind the USD/JPY exchange rate reaching a new high

December 19, Japan’s central bank announced a 25 basis point rate hike, raising the policy interest rate to 0.75%, the highest level since 1995. However, the market’s reaction was unexpected—the USD/JPY exchange rate actually strengthened, and the yen did not receive the support as anticipated. The reasons behind this phenomenon warrant in-depth exploration.

The rate hike signal is not clear enough, market interprets it as “dovish”

Bank of Japan Governor Haruhiko Kuroda did not provide the firm stance investors expected during the press conference. He admitted it is difficult to determine the neutral interest rate level in advance (currently estimated between 1.0% and 2.5%) and stated that this estimate could be revised if possible. This ambiguity in wording led the market to be uncertain about the future pace of rate hikes.

According to market expectations reflected in overnight index swaps (OIS), the BOJ may not raise rates to 1.00% until the third quarter of 2026 at the earliest. Nomura Securities pointed out that only when the central bank’s guidance indicates that the next rate hike could occur earlier than April 2026 will the market see it as a more hawkish policy stance, thereby pushing the yen higher.

The interest rate differential remains unchanged, USD/JPY continues to be under pressure

ANZ Bank strategist Felix Ryan noted that although the BOJ has started a rate hike cycle, the strengthening of the USD/JPY exchange rate reflects market pessimism about the future rate hike intensity by the central bank. With the interest rate differential still unfavorable to the yen, he expects the yen to continue underperforming G10 currencies over the next year. The bank forecasts that by the end of 2026, USD/JPY will rise to 153.

DFA Investment Management strategist Masahiko Loo also maintains a medium-term target of 135-140 for USD/JPY. He pointed out that the Federal Reserve’s accommodative policy environment and increased hedging activities by Japanese investors continue to support the dollar’s appreciation.

Slow policy shift, market expectations fall short

From the market reaction, the BOJ’s rate hike decision was interpreted as a relatively moderate policy adjustment. Japanese investors are increasing their foreign exchange hedging ratios from historic lows, indirectly reflecting cautious attitudes toward the yen’s appreciation prospects. Only when the BOJ provides a clear timetable for rate hikes and a higher neutral interest rate forecast can the market’s view of the yen truly change.

Under the current circumstances, the upward trend of USD/JPY seems difficult to reverse in the short term unless the BOJ signals a more hawkish stance in subsequent communications.