Will the Yen exchange rate continue to appreciate?

Since the beginning of this year, the yen-dollar exchange rate has become increasingly linked to Japan’s long-term interest rates. The Bank of Japan (central bank) has made clear steps toward a “world with interest rates,” and the rise in yen interest rates is strongly seen by the market as a factor in the appreciation of the yen and the depreciation of the dollar. In the future, the yen exchange rate may be more affected by domestic interest rates in Japan than by US interest rates.

If you compare the charts of the yen exchange rate and Japan’s long-term interest rates together, you will clearly see that until last year, the yen exchange rate had almost no reaction to rising interest rates, but since 2025, the linkage between the two has increased. Foreign exchange rates can reflect the interest rate difference between two currencies, but because the Bank of Japan has long been pursuing a negative interest rate policy, the yen exchange rate has been affected by the trend of US monetary policy.

After the Bank of Japan lifted its negative interest rate policy in the spring of last year, the state of near-zero interest rates continued, and the linkage between the yen exchange rate and the yen interest rate was weak. However, this situation changed after the Bank of Japan raised the policy rate to around 0.5% at its financial policy decision meeting in January this year. Speculations of a new round of interest rate hikes ahead of schedule surfaced, and in this case, long-term interest rates rose to about 1.455% on February 21, reaching the highest level in about 15 years. Driven by the rise in long-term interest rates, the yen exchange rate also rose, breaking through the 150 yen mark of 1 dollar.

“Perhaps we need to pay close attention to the yen and prepare for unexpected yen appreciation,” said Yukiji Fukaya of Market Risk Advisory, Japan. As the market’s vigilance against the simultaneous economic slowdown and price increases in the US economy has intensified, investment funds will more easily flow to Japan, which insists on the path of raising interest rates.

As one of the major currencies, the euro is unlikely to become a target for investment funds. The reason is that in the German general election on February 23, the largest opposition party, the “Union Party”, composed of the Christian Democratic Union (CDU) and the Christian Social Union (CSU), is expected to return to power, and the outlook for the eurozone economy remains uncertain.

The policy changes of the central bank also make it easier for the market to pay attention to the dynamics of the Bank of Japan. Compared with the Fed’s previous rate cuts, the Bank of Japan’s rate hikes are extremely slow, and the market tends to pay more attention to the Fed’s monetary policy operations than the Bank of Japan. In September last year, the Fed decided to cut interest rates by 0.5%, and by December last year, three consecutive meetings implemented a flexible rate cut of 1% in total. In contrast, after the Bank of Japan decided to raise interest rates in July last year, it did not make a decision to raise interest rates further until January this year, with a gap of about half a year.

However, after entering 2025, the situation between Japan and the United States has reversed. In February, Federal Reserve Chairman Powell stated in his testimony to the U.S. Congress that “there is no urgent reason to rush to cut interest rates again” and took a wait-and-see attitude, while Bank of Japan’s review committee member Takada Hajime said in his speech: “If (economic and price) expectations are realized, it will enter a further gear shift stage,” showing a positive attitude towards additional rate hikes. The current market is shifting to an environment where it is easier to pay attention to the Bank of Japan’s policy operations than the Fed.

However, there are also skeptical views on the further appreciation of the yen. Judging from the yen buying and selling trends of hedge funds and other speculators relative to the dollar calculated by Mizuho Bank based on data from the U.S. Commodity Futures Trading Commission (CFTC), speculative yen buying and dollar selling has expanded rapidly since February.

Daisuke Karakama of Mizuho Bank pointed out that “it is rare for speculative yen buying to increase so much in a short period of time,” and pointed out that yen selling for the purpose of profit-taking may increase rapidly depending on the situation. Supporting hedge funds’ buying of yen is the market’s expectation that the Bank of Japan will be positive about raising interest rates as soon as possible. If the Bank of Japan shows a cautious attitude towards raising interest rates as soon as possible, it is undeniable that yen selling will accelerate.

For the Bank of Japan, the sharp fluctuations in the yen exchange rate are an obstacle to flexible policy operations. With the market paying attention to the Bank of Japan’s dynamics, dialogue with the market has become increasingly important.