Does the central bank's rate hike lead to depreciation? The market paradox behind the yen hitting a 30-year high

On December 19, the Bank of Japan announced a 25 bps rate hike, raising the policy interest rate to 0.75%, the highest level since 1995. The statement indicated that if economic and price outlooks meet expectations, the BOJ will continue to pursue rate hikes. However, after the rate hike announcement, the USD/JPY exchange rate actually rose, a seemingly counterintuitive phenomenon that has become a hot topic in the market.

Rate hike signals not hawkish enough, market reaction remains lukewarm

Governor Kazuo Ueda’s attitude at the press conference became the key. He did not provide clear guidance on the timing of the next rate hike, instead emphasizing the difficulty in pre-determining the neutral interest rate level and plans to adjust the estimated range of the neutral rate (currently 1.0%–2.5%) based on circumstances.

This cautious wording was interpreted by the market as a “dovish” signal. Felix Ryan, a strategist at ANZ Bank, pointed out that although the Bank of Japan has initiated a rate hike cycle, the rising USD/JPY exchange rate precisely reflects the market’s lack of clear expectations regarding the pace and magnitude of future rate hikes by the BOJ. Despite expectations that the central bank will continue to raise rates until 2026, due to the still-unfavorable interest rate differential for the yen, ANZ Bank forecasts USD/JPY will reach 153 by the end of 2026.

Diverging views: when will the yen reverse?

Masahiko Loo, a strategist at Dimensional Fund Advisors, believes the market may interpret this rate hike as a dovish signal, causing short-term volatility in the yen. Considering the support from the Federal Reserve’s easing policies and Japanese investors increasing their foreign exchange hedging ratios, the firm maintains a longer-term target of 135–140 for USD/JPY.

On the other hand, the overnight index swap (OIS) market shows that traders expect the BOJ to raise interest rates to 1.00% by Q3 2026. Nomura Securities pointed out that only when the BOJ explicitly signals that the next rate hike will occur earlier than April 2026 will the market see it as a true hawkish signal, thereby driving yen buying. In other words, without a significant upward revision of the neutral rate estimate, it will be difficult for the BOJ to convince the market that the terminal rate will further rise.

A 30-year warning from the yen exchange rate chart

Historical data from the past 30 years of the yen exchange rate shows that when the interest rate differential favors the yen, the exchange rate often experiences a reversal opportunity. The current dilemma is that the interest rate differential between Japan and the US remains substantial, which means that even if the BOJ hikes rates, the yen may still lag among G10 currencies in the short term. The market is waiting for a stronger policy signal to truly reverse the yen’s downward trend.