Summary of Key Points
Recently, the Japanese yen has weakened against the US dollar to its lowest level since 1986, while the yield on Japan's 10-year government bonds has reached a 30-year high. These two developments are highly unusual: firstly, despite Japan's interest rate hikes (which should normally lead to a currency appreciation), the yen is still declining; secondly, the yen and Japanese bonds typically move in opposite directions (bonds are considered a safe haven during currency depreciation). The reason for this is the market's lack of confidence in the high-government's policy mix of "expansionary fiscal measures and limited interest rate increases," which has raised concerns about the riskiness of Japanese assets. Japan cannot afford to let the yen continue to depreciate, as the benefits are diminishing (weak economic growth) and the political pressure is increasing (affecting election promises), especially with escalating tensions between the US and Japan.
There are three possible approaches to address this situation: foreign exchange intervention (with limited effectiveness), accelerating interest rate hikes (which could harm the finances and bond market), or waiting for the Federal Reserve to cut interest rates (with uncertainty). In the long run, the only sustainable solution lies in rectifying Japan's fiscal policies.
The Unusual Depreciation of the Yen
Historically, when the central bank raises interest rates, the currency appreciates (higher interest rates attract foreign capital); when the yen depreciates, bond prices rise (capital seeks safe-haven bonds). However, this time the situation is reversed:
- Depreciation despite interest rate hikes: Japan started raising interest rates in March 2024 after exiting negative interest rates, but the yen continued to weaken because the market doubted the sustainability of these measures (due to government restrictions on the central bank).
- Simultaneous decline in the yen and bonds: This indicates that investors are unwilling to hold either the yen or Japanese bonds, reflecting a crisis in confidence in Japan's policies—fear that the government is borrowing too much (through fiscal expansion) without allowing the central bank to raise interest rates sufficiently, potentially leading to debt repayment difficulties.
Why Can't Interest Rate Hikes Stop the Depreciation?
Several factors contribute to this:
1. Arbitrage transactions: Although the interest rate gap between the US and Japan has narrowed, the Federal Reserve's rates are still 2.5-2.75 percentage points higher. For example, borrowing 1 million yen at lower interest rates and converting it into US dollars to invest in US assets generates a profit that encourages investors to sell the yen.
2. Capital outflows and speculation: Japanese companies are keeping the foreign earnings they earn overseas instead of converting them back into yen for reinvestment. Hedge funds are bearish on the yen, with the situation being as severe as since 2007. Additionally, Middle East conflicts have pushed up oil prices, increasing Japan's expenditure on energy and further weakening the yen.
3. The government's policy mix: High-government officials are promoting expansionary fiscal policies while urging the central bank to be cautious with interest rate hikes. The market is concerned that the central bank may not raise rates enough, leading to low yen interest rates and a lack of demand for Japanese bonds.
The Yen Depreciation Cannot Be Ignored Any Longer
In the past, a weaker yen was beneficial for Japan: it boosted export companies' profits (more overseas income converted into yen) and attracted tourists. However, the current situation is problematic:
- Economic impacts: A 10% depreciation of the yen used to boost GDP by 0.25%, but now it only increases GDP by 0.14% due to rising energy costs and US tariffs. The increased cost is borne by ordinary consumers, with a record number of company bankruptcies in the first half of 2026, especially in the wholesale and retail sectors.
- Political consequences: High-government election promises to reduce living costs have been undermined by currency depreciation, leading to voter dissatisfaction.
- Tensions with the US: The US has already included Japan on its foreign exchange monitoring list, and the US Treasury Secretary has signaled that Japan should not expect joint intervention. Further yen depreciation could trigger trade tensions.
Three Approaches, All with Challenges
1. Foreign Exchange Intervention: This would provide temporary relief but is unlikely to be effective. The Japanese Finance Ministry spent 11.73 trillion yen in interventions between April and May 2026, but the yen only rose briefly before falling again. This is because:
- Reserving foreign exchange to counter capital outflows is always challenging; frequent interventions may signal a lack of funds.
- Selling US assets could raise US interest rates, affecting Japan's economy.
2. Accelerating Interest Rate Hikes: While this would narrow the interest rate gap, it would harm Japan's finances and bond market:
- Japan's debt (204% of GDP) currently results in annual interest payments of 10 trillion yen, which could rise to 25.8 trillion yen by 2034 with higher interest rates.
- The bond market would face additional pressure, with more people selling bonds and driving up yields.
- Government restrictions on interest rate hikes may undermine the central bank's credibility.
3. Waiting for the Fed to Cut Rates: This relies on luck, as US inflation remains high (above 2%), and Middle East conflicts could prevent the Fed from cutting rates. During this period, the yen might depreciate further, and the market might criticize the central bank for inaction.
The Long-Term Solution: Fiscal Reform
The market's main concern is Japan's debt. Although some argue that the net debt (total debt minus government assets) is only 130% of GDP, experts point out that this figure is meaningless unless the government sells its assets to repay the debt. To resolve the issue, Japan needs to:
- Reduce deficits: Achieve a "primary fiscal surplus" (tax revenues exceed non-interest expenditures).
- Sell assets to repay debt: For example, by selling government-held financial assets.
- Rebuild market confidence: Only after fiscal reforms will investors trust that Japan can repay its debts, leading to lower bond yields and allowing the central bank to raise interest rates freely, thus resolving both the interest rate gap and currency depreciation issues.
Japan is at a crossroads—either it must take proactive action or wait for economic and financial crises to force changes.