The Bank of Japan raised interest rates to their highest level in 30 years, yet the yen tumbled to record lows. The outcome is the exact opposite of what Japan intended.

With the government now signaling possible intervention in the currency market, uncertainty is only growing.

Japan Warns of “Appropriate Action” as Yen Slides

On Monday, Atsushi Mimura, Japan’s vice finance minister for international affairs and the country’s top currency diplomat, warned that recent foreign exchange movements had been “one-sided and sharp.” He added that authorities are prepared to take “appropriate action” if exchange-rate moves become excessive—a clear signal that currency intervention is on the table. Finance Minister Satsuki Katayama had made similar remarks late last week, saying Tokyo would respond appropriately to excessive and speculative currency moves.

The warnings came as the yen hit historic lows. On Monday, the dollar climbed to 157.67 yen. The euro reached 184.90 yen, and the Swiss franc touched 198.08 yen, both record lows for the Japanese currency. Market participants believe Japanese authorities are likely to intervene if the dollar approaches 160 yen. Last summer, the BOJ sold approximately $100 billion at similar levels to prop up the currency.

Why Is the Yen Weakening Despite a Rate Hike?

Under normal circumstances, raising interest rates strengthens a currency. Higher rates attract foreign capital seeking better returns. On Dec. 19, the BOJ raised its benchmark rate by 0.25 percentage points to 0.75%, the highest level since 1995.

Yet the yen moved in the opposite direction. Several factors explain this paradox.

First, the rate hike was already fully priced in. The overnight index swap market had assigned nearly 100% probability to the move before the meeting. This triggered a classic “buy the rumor, sell the news” reaction. Investors who had bought yen in anticipation of the rate hike sold to lock in profits once the decision was announced, adding downward pressure on the currency.

Second, real interest rates remain profoundly negative in Japan. While the nominal rate rose to 0.75%, inflation is running at 2.9%. This puts the real interest rate—the nominal rate minus inflation—at approximately -2.15%. In contrast, the US has a real rate of around +1.44%, with interest rates at 4.14% and inflation at 2.7%. The gap between Japanese and US real rates exceeds 3.5 percentage points.

This wide differential has revived the yen carry trade. In a carry trade, investors borrow money in a low-interest-rate country and invest it in higher-yielding assets elsewhere. By borrowing yen cheaply and investing in dollar assets, traders can pocket the difference in yields. With real rate differentials still heavily favoring the dollar, investors are again selling yen and buying dollars.

Third, BOJ Governor Kazuo Ueda’s press conference disappointed markets. Speaking on Dec. 19, Ueda offered no clear guidance on the timing of future rate hikes. He emphasized that there was “no predetermined path for further rate hikes” and acknowledged that estimates of the neutral interest rate remain “highly uncertain.” He even downplayed the significance of the decision, stating that reaching the highest rate in 30 years “has no special meaning.” Markets interpreted this as a signal that the BOJ is in no hurry to tighten further, and the yen sell-off accelerated.

Japan’s Structural Dilemma

Robin Brooks, a senior fellow at the Brookings Institution, points to a more fundamental problem. “Japan’s longer-term interest rates are much too low given massive public debt,” he wrote. “As long as that remains true, the yen will continue its debasement cycle.”

Japan’s government debt stands at 240% of GDP, yet its 30-year bond yield is roughly similar to Germany’s—a country with far lower debt levels. This is abnormal. The BOJ has been suppressing yields by purchasing massive amounts of government bonds.

“Without this buying, Japan’s longer-term yields would be much higher, which would push the country into a debt crisis,” Brooks explained. “Unfortunately, given how huge Japan’s debt overhang is, the choice is between a debt crisis and currency debasement.”

Brooks noted that on a factual effective exchange rate basis, the yen now rivals the Turkish lira as the world’s weakest currency.

Adding to the pressure, Prime Minister Sanae Takaichi has pursued aggressive fiscal expansion since taking office in October. This is Japan’s largest stimulus package since the COVID-19 pandemic. With government debt already at 240% of GDP, markets are increasingly concerned that looser fiscal policy could undermine the BOJ’s efforts to stabilize the currency.

Market Impact: Short-Term Relief, Growing Uncertainty

With the yen weakening despite the rate hike, global asset markets are breathing a sigh of relief—for now.

In theory, a rate hike should strengthen the currency and trigger unwinding of the carry trade. As investors rush to repay yen-denominated loans, they sell global assets, draining liquidity and pushing down the prices of risk assets such as stocks and cryptocurrencies.

But reality is playing out differently. With yen weakness persisting, carry trades have been revived rather than unwound.

Japanese equities are benefiting. The Nikkei rose 1.5% on Monday as a weaker yen boosted earnings for exporters like Toyota, as overseas revenues are converted back into yen. Japanese bank stocks have surged 40% year to date, reflecting expectations that higher rates will boost bank profitability.

Safe-haven assets are also rallying. Silver hit a record high of $67.48 per ounce, bringing year-to-date gains to 134%. Gold remains strong at $4,362 per ounce.

However, this relief rests on shaky foundations. It is an “uncertain calm” created by the BOJ’s lack of clear policy guidance. If Japanese authorities intervene in the currency market or the BOJ accelerates rate hikes faster than expected, the yen could surge. That would trigger a rapid unwinding of the carry trade, potentially dragging global assets down with it.

The precedent is fresh. In August 2024, when the BOJ raised rates without explicit advance signaling, the Nikkei plunged 12% in a single day, and Bitcoin tumbled alongside it. Bitcoin has fallen 20-31% following each of the past three BOJ rate hikes.

Outlook: 160 Yen Is the Line in the Sand

In the near term, markets expect dollar-yen to end the year around 155 yen, with thin trading during the Christmas holiday limiting volatility.

However, if the pair breaks above 158 yen, it could test this year’s high of 158.88 yen and then last year’s peak of 161.96 yen. The likelihood of Japanese intervention rises sharply as the rate approaches 160 yen.

Forecasts for the next BOJ rate hike are divided. ING expects a move in October 2026, while Bank of America sees June as more likely—and does not rule out April if the yen weakens rapidly. BofA analysts project the terminal rate will reach 1.5% by the end of 2027.

Yet some analysts warn that even these projections may not be enough. With US rates still above 3.5% and the BOJ at just 0.75%, the interest rate gap remains too wide for the yen to recover meaningfully. Arresting the yen’s decline would likely require the BOJ to raise rates to at least 1.25-1.5%, combined with further Fed rate cuts—a scenario that appears unlikely in the near term.

Japan finds itself walking a tightrope between currency debasement and a debt crisis. Brooks warned that “the political consensus for fiscal consolidation does not yet exist. Yen debasement will have to get worse before that happens.”

Global markets will need to remain alert to Japan-driven volatility in the months ahead.

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